EQUITY ANALYSIS, VALUATION

AND PORTFOLIO
MANAGEMENT

DR M MANICKARAJ
National Institute of Bank Management, Pune India
 NIBM, Pune

Contents

Chapter 1: Introduction to Equity Markets

Chapter 2: Valuation of Equity Stocks

Chapter 3: Portfolio Analysis, Selection and Management

Chapter 4: Capital Market Theories

Chapter 5: Performance Evaluation of Portfolios

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Module II: Security Analysis and Portfolio Management

Section B: Equity Analytics

Chapter 1: Introduction to Equity Markets

Dr M. M Manickaraj

Objective
The objective of this chapter is to give an introduction to equity stocks and equity
markets.

Structure
The chapter has been organised as follows:
1. Characteristics of equity stocks
1.1. Separation of ownership and management
1.2. Limited liability
1.3. Residual claim
1.4. Infinite life
2. Types of equity stocks
3. Equity markets
3.1. Primary markets
3.2. Secondary markets
3.3. Equity markets in India
4. Trading in equities
4.1. Types of trading
4.1.1. Cash trade
4.1.2. Margin trade
4.1.2.1. Margin requirements
4.1.2.2. Securities eligible for margin trading
4.1.3. Short selling
4.1.3.1. Rollover SLB facility
4.1.4. Intraday trade
4.2. Stamping of trades
4.3. Types of orders
4.4. Cost of trading
4.5. Market making
4.6. Containing price volatility
4.6.1. Pre-Open session
4.6.2. Circuit filters
4.6.3. Scrip wise price band

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4.7. Summary
1. Characteristics of Equity Shares
Business firms raise capital by issuing different types of securities like equity shares,
preference shares, bonds and short-term instruments like commercial papers. Capital
raised through equity shares1 is ownership capital that will remain in business as long as
the business firm exists. Equity stocks offer high returns to the investors and are
considered to be one of the most attractive avenues for investment. However, making
high returns depends on one’s ability to value the stocks correctly and making investment
at the right time. The basic characteristics of equity stocks are discussed hereunder.

1.1 Separation of ownership and management

Large business firms raise capital through the issue of equity shares to the public because
the entire capital required for large businesses cannot be brought by few promoters
alone. As such, the number of shareholders, generally, is large and scattered all over the
country/world. All of them cannot participate in running the business. Besides, majority
of the shareholders may not have the knowledge, skill and time to run a business.
Shareholders (owners) therefore, appoint a management who in turn run the business in
the interests of the shareholders. Shareholders control the management by exercising
their powers to appoint and change the management by using their voting rights.

1.2 Limited liability

The shareholders’ liability towards a business firm is limited to the capital invested by
them in the firm. This is in contrast to proprietorship firms and partnership firms where
the liability of owners extends beyond their capital to include their personal properties
and income.

1.3 Residual claim

Equity shareholders are the last in the line of those who have a claim over the assets and
income of a company. In case of a going concern, the equity shareholders are entitled to
the profits remaining after paying the claims of all other stakeholders including
government, employees, suppliers and creditors. Similarly, on liquidation of the
business, they can claim the residuals remaining after settling the claims of all other
stakeholders.

1.4 Infinite life

Unlike most other financial securities equity shares have an infinite life. Business firms,
especially listed companies are perpetual entities and the equity shares issued by these
business firms also have an infinite life. Therefore, equity shareholders cannot get
repayment of their investment from the company, excepting in case of share buyback. If
they want to withdraw their investment they can do so by selling the shares in the
secondary market only.

1
The terms ‘equity shares’ and ‘equity stocks’ mean the same and are used interchangeably in this booklet.

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2. Types of Equity Stocks

Equity stocks can be classified into various categories and the major categories are as
follows:
• Value stocks: Those stocks which are fundamentally strong but trading at a price
much lower than their intrinsic value are called value stocks. These stocks would
offer very high returns if held for a longer period of time. However, identifying
stocks demands a detailed fundamental analysis.
• Growth stocks: Equity stocks of those companies whose earnings are growing very
fast are called growth stocks.
• Cyclical stocks: Stocks of companies in cyclical sectors which are highly sensitive
to the changes in overall economic condition are called cyclical stocks. For
instance, stocks of cement companies, steel companies, capital goods companies
may be called cyclical stocks.
• Defensive stocks: Stocks of companies which are least affected by macroeconomic
conditions may be called defensive stocks. Examples of defensive stocks include
pharma stocks, FMCG stocks and the like.
• Sector stocks: Stocks of companies belonging to specific sectors like IT sector,
banking sector, metal sector, real estate sector, and son on.
• Large cap stocks: These are the stocks of very big companies in the market. The
size is decided based on market capitalisation of the companies.
• Mid cap stocks: Companies which are neither very big nor small in terms of market
capitalisation may be called mid cap companies and their equity shares as mid cap
stocks.
• Small cap stocks: Shares of small cap companies are called small cap stocks.
• Others: There are several other categories of stocks like green stocks, sharia
stocks, etc. Green stocks are the stocks of companies which are environmentally
friendly activities and the companies which are running their business in an
environmentally friendly manner. Sharia stocks are those which comply with the
tenets of Islam.

3. Equity markets
Equity markets are broadly of two types – primary market and secondary market. A
brief description of the two markets is as follows:

3.1 Primary market

Business firms raise capital to start businesses. They may also raise additional capital for
financing expansion and new ventures. They raise capital through issue of different types
of securities including equity shares. The market for such new securities is called the
primary market. Equity capital can be raised using any of the following methods:

- Rights issue – issuing shares to existing shareholders

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- Initial Public Offering (IPO)/Follow-on Public Offering (FPO): Shares being

issued by a new company is called IPO and new shares issued by an existing
company are called FPO. IPO/FPO may include any one or combination of
the following:
 Private placement
 Qualified institutional placement (QIP)
 Public offer
 Rights issue

IPOs/FPOs can be made with either a fixed price or a range of price. If it is fixed price
the buyers have to necessarily buy the shares at that price and have no freedom to quote
a price. The second method is called book building method wherein the issuing
company will fix a price band and the buyers will have the freedom to quote a price within
that band. This method has become very popular and now-a-days almost all the
companies in India raise equity capital via IPOs/FPOs following this method.

3.2 Secondary markets

As equity shares cannot be sold back to the company that has issued the shares the only
exit route for the equity shareholders is selling in the secondary market. The secondary
market for equity shares is the stock exchanges. They provide a platform for the buyers
and sellers to meet and thereby facilitate trading in stocks.

3.3 Equity markets in India

Stock market transactions in India dates back to late 18th century and the loan securities
of the East India Company were the first to be traded. Corporate securities came to the
Indian market during 1830’s and gained importance with the enactment of the
Companies Act 1850. Organised trading in securities started with the formation of the
Native Share and Stock Brokers Association in 1887 (now it is known as the Bombay
Stock Exchange). Subsequently, many regional stock exchanges were set up. First
regional exchange was the Ahmedabad Share and Stock Brokers Association formed in
1894. Over time 19 other regional stock exchanges were established. One major
development in the stock market history of India is the setting up of the National Stock
Exchange (NSE) in 1992 which started its operations in 1994. Another major
development is the enactment of the Securities and Exchange Board of India Act 1992.
These two incidents coincided with the liberalisation of the Indian economy. Since then
many things have happened in India that have transformed the Indian securities markets
and made them one of the most modern markets in the world. Significant developments
are the following:
 Introduction of National Exchange for Automated Trading (NEAT). It is a fully
automatic screen based trading system. This system matches buy and sell orders
through an automated process and anonymously. This enables reducing the time
and cost substantially.

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 Dematerialisation of stocks – all the stocks were dematerialised that enabled

electronic settlement of trades. This led to substantial reduction in transaction
costs.
 Creation of depositories: A depository is an organisation which holds securities
(like shares, debentures, bonds, government securities, mutual fund units etc.) of
investors in electronic form at the request of the investors through a registered
depository participant. It also provides services related to transactions in
securities. There are two depositories in India – National Securities Depository Ltd
(NSDL) and Central Depository Service (India) Ltd (CSDL). The services offered by
the depositories are:
o Dematerialisation (usually known as demat) of securities.
Dematerialisation is the process by which physical certificates of an
investor are converted to an equivalent number of securities in electronic
form.
o Rematerialisation (known as remat). Rematerialization is the process of
converting securities held in electronic form in a demat account back in
physical certificate form.
o Transfer of securities and change of beneficial ownership
o Settlement of trades done on stock exchanges connected to the
Depository
o Pledging and unpledging of securities for loan against shares
o Transfer of corporate action benefits like dividends directly to the Demat
and Bank account of customers

Investors can avail the services of depositories through a Depository Participant (DP)
only. A DP is an agent of the depository through which it interfaces with the investor
and provides depository services.

 Creation of clearing corporations which act as the central counter party for the
trades. When a buy order in an exchange matches with a sell order, a trade is
generated. The central counterparty steps in between the buyer and the seller
and acts as a buyer to every seller and a seller to every buyer guaranteeing
settlement of trades. This process is called novation. Clearing corporations
maintain funds for guaranteeing trades, settlement and in case a buyer or a seller
defaults. The following five clearing corporations operate in India.
o National Securities Clearing Corporation Ltd.
o Indian Clearing Corporation Ltd.
o Metropolitan Clearing Corporation of India Ltd.
o India International Clearing Corporation (IFSC) Limited
o NSE IFSC Clearing Corporation Limited
 Introduction of derivatives. Since June 2000 variety of derivative instruments
have been allowed in the Indian stock exchanges which include index futures,

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index options, stock futures, stock options, currency futures, interest futures,
futures on global indices like Dow Jones Industrial Average (DJIA), S&P 500 index.
 Introduction of debt instruments for trading
 Listing and trading of Exchange Traded Funds (ETFs)
 Listing and trading of mutual funds

3.3.1 Players in the Market

The various players in equity market are listed below.

• Investors
• Domestic institutional investors (DIIs)
• Mutual funds
• Commercial Banks
• Venture capital funds
• Private equity funds
• Insurance companies
• Pension funds
• Provident funds
• Foreign institutional investors (FIIs)
• Retail investors
• Intermediaries
• Merchant bankers
• Broking companies
• Depositories
• National Securities Depository Ltd (NSDL)
• Central Depository Services India Ltd (CDSL)
• Banks

3.3.2 Share price indices

According to the Financial Dictionary (https://financial-
dictionary.thefreedictionary.com/share+price+index) a share price index is a a group of
stocks put together in a standardized way to provide a useful window into a sector or
market's performance at a glance. That is, a stock index groups together a certain list of
stocks and usually takes an average of their prices so as to provide an idea of how the
industry or market represented in the stock index is doing. Very often, stock indices are
weighted to prevent a few data points from overwhelming it. For example, the S&P 500
is weighted according to market capitalization, while the DJIA is weighted for price. In
India, both the BSE and NSE have introduced many indices which measure the movement
in the prices of stocks. For instance, the indices offered by the NSE are as under. Thee BSE
also offers variety of indices. Among the various indices BSE Sensex and NSE’s Nifty 50
are the most popular.

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Broad Market Indices

o NIFTY 50
o NIFTY NEXT 50
o NIFTY 100
o NIFTY 200
o NIFTY 500
o NIFTY MIDCAP 50
o NIFTY MID100 FREE
o NIFTY SML100 FREE
o INDIA VIX

Sectoral Indices
o NIFTY BANK
o NIFTY AUTO
o NIFTY FIN SERVICE
o NIFTY FMCG
o NIFTY IT
o NIFTY MEDIA
o NIFTY METAL
o NIFTY PHARMA
o NIFTY PSU BANK
o NIFTY PVT BANK
o NIFTY REALTY

Strategy Indices
o NIFTY DIV OPPS 50
o NIFTY GROWSECT 15
o NIFTY QUALITY 30
o NIFTY50 VALUE 20
o NIFTY50 TR 2X LEV
o NIFTY50 PR 2X LEV
o NIFTY50 TR 1X INV
o NIFTY50 PR 1X INV
o NIFTY50 DIV POINT

Thematic Indices
o NIFTY COMMODITIES
o NIFTY CONSUMPTION
o NIFTY CPSE

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o NIFTY ENERGY
o NIFTY INFRA
o NIFTY100 LIQ 15
o NIFTY MID LIQ 15
o NIFTY MNC
o NIFTY PSE
o NIFTY SERV SECTOR

Fixed Income Indices

o NIFTY GS 8 13YR
o NIFTY GS 10YR
o NIFTY GS 10YR CLN
o NIFTY GS 4 8YR
o NIFTY GS 11 15YR
o NIFTY GS 15YRPLUS
o NIFTY GS COMPSITE

The chart below shows the movement in the value of Nifty 50 index during the two years
2016 and 2017. The index values on January 1, 2016 was 7963.2 and on December 27,
2017 it was 10490.75 indicating that the index return during these two years period was
32%. If you have a closer look at the chart it will be clear that during 2016 the change in
the value of the index was negligible and the rise in the value during 2017 was significant.
In fact, the percentage change in the value of Nifty 50 during 2016 was around 1% and
the change during 2017 was around 31%.

Chart 1: Movement in Nifty 50 Index

Nifty 50
11000
10500
10000
9500
9000
8500
8000
7500
7000
6500
6000
42675

42917

43070
42370
42401
42430
42461
42491
42522
42552
42583
42614
42644

42705
42736
42767
42795
42826
42856
42887

42948
42979
43009
43040

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4. Trading in equities
In India, there are two leading national level stock exchanges, namely, the Bombay Stock
Exchange (BSE) and the National Stock Exchange (NSE). There are twenty other regional
exchanges. Presently, trading in the regional exchanges is almost nil and practically BSE,
NSE and MCX SX are the only three exchanges which are operational. Around 5800
companies have been listed on the BSE and around 1800 companies have been listed on
the NSE. However, NSE is the largest stock exchange in the country accounting for more
than 75% of trading volume.

One can trade in these stock exchanges only through a member of an exchange concerned.
The members are called the stock brokers. To buy or sell equities in the stock exchanges
an investor must have opened the following three accounts:
• Trading account with a broker
• Demat account with a depository
• Bank account

In addition, Permanent Account Number (PAN) provided by the Income Tax Department
is mandatory for trading in stock exchanges.

All buy and sell transactions of an investor are recorded in his trading account. Now a
days, all the equity shares are in electronic form (dematerialized form) and all the
transactions are settled electronically. The demat services (electronic record keeping
and settlement) are offered by two depositories – (1) Central Depository Services India
Limited (CDSL) and (2) National Securities Depository Limited (NSDL). To avail these
services investors have to open an account with either of the two depositories. An
investor cannot, however, open a demat account directly with a depository. They can
open an account with a depository participant only. Depository participant is one who
has an account with CDSL or NSDL. All the buy transactions are credited in the demat
account and all the sell transactions are debited.

To settle money involved in the transactions one needs to have a bank account. Many
banks particularly the new generation banks like ICICI Bank, HDFC Bank, IDBI Bank and
Axis Bank have tied up with most of the broking firms and provide electronic clearing
services (ECS) through which funds are transferred electronically. ECS facilitates instant
transfer of funds to and from the trading account. If an investor has an account with a
bank which does not provide ECS, his transactions will be settled through cheques.

4.1 Types of trading

There are four different types of trades that can be made in the stock exchanges in India,
namely, cash trade, margin trade, short selling, and intraday trade.

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4.1.1 Cash trade

Buying or selling stocks for delivery is called cash trade. Buyers pay cash and take
delivery of the stocks bought. Sellers, on the other hand, deliver stocks and receive
payment of cash.

4.1.2 Margin trade

Those who want to buy for a very short period of time can do so with a limited amount of
money called margin money. The balance will be provided by the broker as loan.
Investors can, therefore, buy stocks worth several times their own money. The settlement
cycle in India is T+2. That is, any transaction should be settled within the next two trading
days. In case of margin trades the broker will pay cash and settle the transaction.
However, as per the regulations in India, margin trades should be settled by the actual
buyers within a period of one week and the loan taken from the brokers should be settled
on or before T+8. If the buyer does not bring in money to pay the lender, the
lender/broker will sell the stocks and will take his principal and interest. Balance, if any,
will be paid to the investor.

4.1.2.1 Margin requirements

Two types of margin, namely, initial margin and maintenance margin need to be
maintained for margin trading. “Initial margin” means the minimum amount, calculated
as a percentage (50%) of the transaction value, to be placed by the client, with the broker,
before the actual purchase. “Maintenance margin” means the minimum amount,
calculated as a percentage (40%) of the market value of the securities, calculated with
respect to the last trading day’s closing price, to be maintained by the client with the
broker.

One may raise the question, what if the margin money of an investor is not sufficient to
settle the transactions. This question is highly relevant particularly during periods of
high volatility in stock prices. During market crashes when prices of stocks fall drastically,
the margin will be revised upward and the investors will be asked to bring in additional
money. This is called margin call. In fact, the stock exchanges and brokers have the
discretion to increase the margins and in such a case, the margin call shall be made, as
and when required. If an investor fails to bring the additional money immediately, his
holdings will be disposed off by the broker without any further notice. Such actions will
lead to increase in the supply of shares substantially and would lead to fall in prices
further down. Fixed deposits with banks and Bank Guarantees shall be treated as cash
equivalents and shall be considered as acceptable form of initial and maintenance
margins for the purpose of availing the Margin Trading Facility

4.1.2.2 Securities eligible for margin trading

The securities in Group 1 would be eligible for margin trading facility. In addition to the
Group 1 securities, all the securities which are offered in the Initial Public Offerings

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(IPOs) and which meet the conditions for inclusion in the derivatives segment of the
Stock Exchanges would be eligible for Margin Trading Facility.

Only corporate brokers with a “net worth” of at least Rs.3.00 crore would be eligible to
offer margin trading facility to their clients.

4.1.3 Short selling

SEBI issued a notification, on December 20, 2007, permitting short selling in select stocks
and a broad framework for short selling by institutional investors and a full-fledged
securities lending and borrowing (SLB) scheme for all market participants were
operationalised with effect from April 21, 2008. Short selling is selling a stock which the
seller does not own at the time of sale. It is a speculative action and he does it because of
his expectation that the stock price will fall within the next few days and hence he can
close his position by placing a counter order to buy the same stock and of the same
quantity. To facilitate short selling, stock lending is required. Unlike margin trades where
stocks can be bought with borrowed money in case of short selling there is a need for
borrowing stocks which is very difficult. The difficulty is because pooling the stocks in
desired quantity and lending from out of the pool has many constraints. The biggest
constraint is pooling stocks because the stocks are held by the investors and the stocks
available for lending would be very limited.

All classes of investors, viz., retail and institutional investors, are permitted to short sell.
The securities traded in Futures and Options (F&O) segment are eligible for short selling.

All categories of investors are permitted to borrow and lend securities. The borrowers
and lenders shall access the Securities Lending and Borrowing (SLB) platform set up by
the authorised intermediaries (AIs) through the clearing members (CMs) (including
banks and custodians) who are authorized by the AIs in this regard. The settlement cycle
for SLB transactions shall be on T+1 basis.

4.1.3.1 Roll-over SLB facility

Any lender or borrower who wishes to extend an existing lent or borrow position can
roll-over such positions i.e. a lender who is due to receive securities in the pay out of an
SLB session, may extend the period of lending. Similarly, a borrower who has to return
borrowed securities in the pay-in of an SLB session, may, through the same SLB session,
extend the period of borrowing. The roll-over shall be conducted as part of the SLB
session. Roll-over is available for a period of 3 months i.e. the original contract plus 2
rollover contracts.

4.1.4 Intraday trade

After introducing demat trade, buying and selling stocks within the same day has become
possible. Buying is similar to margin trade and selling is similar to short selling. However,

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as the positions will be closed within the same day, the need for lending and borrowing
of money or shares does not arise.

4.2 Time Stamping of Orders

Broker member(s) have to maintain record of time when the client places the order and
reflect the same in contract note along with the time of execution of the order.

4.3 Types of orders

Market order and limit order are the two types of orders an investor can place in a stock
exchange. Placing an order to buy or sell a stock at prevailing market price is called
market order. Limit order, on the other hand, is placing an order by quoting a price limit.
If it is for buying a stock, the price limit indicates that the broker shall execute the buy if
the price is equal to or less than the limit. If it is for selling a stock, the order shall be
executed if the price is equal to or above the limit. If the price does not reach the limit
during the day the order will not be executed.

Stock exchanges in India also offer Bulk Deals and Block Deals in stocks. A Bulk Deal
constitutes all transactions in a scrip (on an exchange) where the total quantity of shares
bought/sold is more than 0.5% of the number of equity shares of the company listed on
the exchange. The quantitative limit of 0.5% can be reached through one or more
transactions executed during the day in the normal market segment. Stock exchanges
shall disclose trade details of ”bulk deals” to the general public on the same day after the
market hours.

Block deal is execution of large trades through a single transaction without putting
either the buyer or seller in a disadvantageous position. For this purpose, stock exchanges
are permitted to provide a separate trading window. Block deal will be subject to the
following conditions:
 The said trading window may be kept open for a limited period of 35 minutes
from the beginning of trading hours i.e. the trading window shall remain open
from 9.15 am to 9.50 am.
 The orders may be placed in this window at a price not exceeding +1% from the
ruling market price/previous day closing price, as applicable.
 An order may be placed for a minimum quantity of 5,00,000 shares or minimum
value of Rs.5 crore.
 Every trade executed in this window must result in delivery and shall not be
squared off or reversed.
 The stock exchanges shall disseminate the information on block deals such as the
name of the scrip, name of the client, quantity of shares bought/sold, traded
price, etc. to the general public on the same day, after the market hours.

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4.4 Costs of Trading

Costs for an investor include commission (brokerage) payable to broker, securities
transaction tax and charges payable to depository.

SEBI allows the brokers to charge not more than 2.5 percent of the transaction value from
their clients. However, due to competition among the brokers, they charge as low as 0.1
percent on trades for delivery and 0.05 percent on intraday trades. However, the
brokerage depends on the volume of business a client gives to his broker and is
negotiable.

Since 2004 Government of India is levying a tax on securities transactions called

Securities Transaction Tax (STT). The STT rates for the assessment year 2017-18 were
0.10 percent on trades for delivery and 0.025 percent on intraday trades. STT on trades
for delivery is payable by both buyers and sellers. Whereas, STT on intraday trades is
payable by sellers only.

Apart from the brokerage and STT, the investors have to pay fees to the depository for
its services. See the Annexure 1.1 for the details of charges levied by ICICI Securities Ltd,
one of the largest brokerage firms in India, for various charges to be paid by investors for
trading in the Indian stock exchanges.

4.5 Market Making

There are many scrips in which trading activity is very limited and are called illiquid
stocks. In order to create liquidity there is a need for motivating brokers to create market
for these stocks. The stock exchanges shall formulate its own benchmarks for selecting
the scrips for market making, however, the shares satisfying any of the following criteria
would not be eligible for market making:
 Shares included in the BSE Sensex and the Nifty 50;
 Shares where the average number of trades is more than 50;
 Shares where the value of trades on a daily basis is more than Rs.10,00,000;
 Shares where the company is not in operation and the Net worth erosion is
beyond 50%

The market making is allowed on a voluntary basis. Therefore, if Market Maker is not
available for such shares, the share will continue to be traded under the existing system.

4.6 Containing Price Volatility

One major source of risk to investors in equity stocks is the price volatility. Though
volatility in stock prices is quite inherent in nature very high volatility may ruin investors.
In order to contain the risk of price volatility SEBI has introduced the following two
mechanisms:
 Pre-open session

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 Circuit filters

4.6.1 Pre-Open Session

India’s two premier exchanges — NSE and BSE — introduced the 15 minute special pre-
open trading session, a mechanism under which investors can bid for stocks before the
market opens. The mechanism came into operation on October 18, 2010. The mechanism
is known as ‘pre-open session call auction’ and the duration of the session is 15 minutes
(from 9:00—9:15 a.m.) out of which eight minutes shall be allowed for order entry, order
modification and order cancellation, four minutes for order matching and trade
confirmation and the remaining three minutes shall be the buffer period to facilitate the
transition from pre-open session to the normal market. Initially, only those stocks which
were part of BSE Sensex and NSE Nifty 50 were allowed to be traded during the pre-open
session. However, since April 1, 2013 the session was made applicable to all scrips that
are not classified as illiquid.

The major objective of the pre-open session is to determine the equilibrium price. The
equilibrium price is the price at which the maximum volume is executable. That is the
maximum volume that finds a match between buy orders and sell orders and hence can
be executed.

4.6.2 Circuit Filters

Another major initiative for containing stock price volatility is circuit filters. Stock
exchanges in India have introduced both index based market wide circuit filters and scrip
wise circuit filters.

4.6.2.1 Index based Market wide circuit filter

These circuit breakers are used to stop adverse movements either way. The circuit
breakers are applied at three stages of the index movement either way at 10%, 15% and
20%. The market wide circuit breakers would be triggered by movement of either BSE
Sensex or the NSE Nifty 50 whichever is breached earlier.
 In case of a 10% movement of either of these indices, there would be a 1 hour
market halt if the movement takes place before 1 pm. In case the movement
takes place at or after 1 pm but before 2:30 pm there will be a trading halt for ½
hour. In case the movement takes place at or after 2:30 pm there will be no
trading halt at the 10% level and the market will continue trading.
 In case of a 15% movement of either index, there will be a 2 hour halt if the
movement takes place before 1 pm. If the 15% trigger is reached on or after 1 pm
but before 2 pm, there will be a 1 hour halt. If the 15% trigger is reached on or
after 2 pm the trading will halt for the remainder of the day.
 In case of a 20% movement of the index, the trading will be halted for the
remainder of the day.

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The stock exchange on a daily basis shall translate the 10%, 15% and 20% circuit breaker
limits of market-wide index variation based on the previous day's closing level of the
index.

4.6.2.2 Scrip wise price bands

 In addition to the market wide index based circuit filters, there are individual
scrip wise price bands of 20% either way, for all scrips in the compulsory rolling
settlement except for the scrips on which derivatives products are available or
scrips included in indices on which derivative products are available.

 Appropriate individual scrip wise price bands upto 20% shall be applicable on
those scrips on which no derivatives products are available but which are part of
Index Derivatives.

4.7 Summary
Equity shares are one of the most attractive and popular avenues for investment. Equity
stocks offer very high return and the risk too is high. Valuation of equity stocks is very
complex mainly due to the fact that the equity shareholders are entitled to residual
earnings only and the life of equity stocks is infinite.

The primary as well as secondary markets for equity are very active in India. To invest in
equity stocks one has to open three different accounts, namely, (1) trading account with
a stock broking firm, (2) demat account with a depository participant, and (3) bank
account. Four different types of trades in the market investors can participate. They are,
cash trade, margin trade, short selling and intraday trade. The types of orders one can
place in the market are market orders and limit orders. There are certain costs investors
have to incur while investing in equity stocks. The costs are brokerage payable to brokers,
demat charges payable to depository participants, and securities transaction tax payable
to the government.

The Indian equity markets are well developed and there are millions of investors
including retail investors, corporates, foreign institutional investors, and domestic
institutions like mutual funds, banks, insurance companies, pension funds, provident
funds and the like participating in the market.

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Annexure 1.1

ICICI Direct Stock Trading, Demat, Brokerage 2017

ICICI Direct Brokerage Charges 2017

 Trading Account Opening Charges (One Time): Rs 975

 Trading Annual maintenance charges (AMC): Rs 0
 Demat Account Opening Charges (One Time): Rs 100 (for Agreement Stamp
Paper)
 Demat Account Annual Maintenance Charges (AMC): Rs 500 (Rs 0 for 1st year
with 3 in 1 Account)

ICICI offers 2 types of brokerage plans to its customer:

1. I-Secure Plan (Flat brokerage Plan)

This plan offers Flat Brokerage (in %) irrespective of turnover value. This plan is
suitable for traders / investors looking at secured and fixed brokerage.

2. I-Saver Plan (Variable brokerage plan)

This plan offers brokerage based on the trading volume i.e. high brokerage for
low volume and low brokerage for high volume trades. This plan suitable for
traders / investors who trade in high volumes and can benefit from low
brokerage.

ICICIDirect Cash Brokerage

I - Saver Plan
Total Eligible Turnover (Per Brokerage Effective Brokerage on
calendar Quarter) (%) Intraday Squareoff
Above Rs 5 Crores 0.25 0.125%
Rs 2 Crores to 5 Crores 0.30 0.150%
Rs 1 Crores to 2 Crores 0.35 0.175%
Rs 50 Lakhs to 1 Crores 0.45 0.225%
Rs 25 Lakhs to 50 Lakhs 0.55 0.275%
Rs 10 Lakhs to 25 Lakhs 0.70 0.350%
Less than Rs 10 Lakhs 0.75 0.375%

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I - Secure Plan
Total Eligible Turnover (Per Brokerage (Equity Effective Brokerage on
calendar Quarter) Delivery %) Intraday Squareoff
Irrespective of turnover 0.55% 0.275%

ICICI Margin & Margin Plus Trading Brokerage

I - Saver Plan / I - Secure Plan

Total Eligible Turnover per month Brokerage (%)
Above Rs 20 Crores 0.030
Rs 10 Crores to 20 Crores 0.035
Rs 5 Crores to 10 Crores 0.040
Less than Rs 5 Crores 0.050

ICICI Other Brokergae Charges

1. Minimum Brokerage ICICIDirect: ICICI charges minimum brokerage of Rs 35 per

trade or 2.5% of the trade value whichever is lower.
2. ICICI charges flat 5 paisa per share (Rs 0.05) brokerage on stocks priced less
then Rs 10 per share.

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ICICI Depository Service Charges

For Resident Retail Customers and Corporates

Particulars Charges
Account Opening Nil
First Year AMC Nil
Rs 600 (Rs 500 for customers
Annual Maintenance Charges
receiving e-mail statements)
Buy - Market and Off-Market Nil
Max. Rs 500 for debt
Sell - Market and Off-Market and Redemption of MF instruments
units (% of transaction value of each ISIN) Nil for Trades done on
www.icicidirect.com
Instruction submitted through Internet (E-inst / 0.04% (Min. Rs 25 and Max. Rs
IVR) 25,000)
0.04% (Min. Rs 30 and Max. Rs
Instruction submitted through Call Centre
25,000)
0.04% (Min. Rs 35 and Max. Rs
Instruction submitted at Branches
25,000)
Rejection / fails Rs 30
Extra charges for processing of TIFDs submitted late
(% of transaction value)
Nil
Instruction submitted through Internet (E-inst /
IVR)
Instruction submitted through Call Centre Nil
Instruction submitted at Branches (accepted at
Rs 10 per ISIN
Client's risk)
Dematerialisation for each request form Rs 50
Dematerialisation for each extra certificate Rs 3
Rs 25 for every hundred
securities or part
thereof, subject to maximum fee
Rematerialisation
of Rs 3,00,000 or
a flat fee of Rs 25 per certificate,
whichever is higher.
Reconversion of MF units Rs 25 per instruction
Closure of Account Nil

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For Resident Retail Customers and Corporates

Particulars Charges
Pledge Creation/Closure/Confirmation/ Invocation
0.02% (Min. Rs 25 and Max. Rs
(% of value for each ISIN in each request)
25,000)
If, ICICI Bank is counter party
0.04% (Min. Rs 35 and Max. Rs
If, ICICI Bank is not counter party
25,000)
Additional Account Statements Rs 20

NSDL Charges (Depository Charges)

Particulars Charges
Annual Maintenance Fee for
Rs 500 p.a. (w.e.f October 1, 2013)
Corporate Account
Rs 4.50 per debit instruction (Nil for commercial paper
Sell - Market and Off-Market
and short-term debt instruments)
Reconversion of MF units
Rs 10 per instruction (w.e.f April 1, 2014)
into SoA
Redemption of MF units
Rs 4.50 per instruction (w.e.f April 1, 2014)
through Participants
A fee of Rs 10 for every hundred securities or part
Remat thereof, subject to maximum fee of Rs 5,00,000 or a flat
fee of Rs 10 per certificate, whichever is higher.
Pledge Creation Rs 25 per instruction

Source: http://www.chittorgarh.com/stockbroker/icicidirect/1/# Accessed on June

23, 2017.

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Chapter 2: Valuation of Equity Stocks

Objective
The objective of this section is to demonstrate the valuation of equity stocks using
various methods and models.

Structure
1. Introduction
2. Balance sheet based approaches
2.1. Liquidation value approach
2.2. Replacement value approach
3. Dividend discount models
3.1. Zero dividend growth model
3.2. Constant dividend growth model
3.2.1. Value of growth opportunities
3.2.2. Increasing the value of stocks
3.3. Variable dividend growth model
3.3.1. Two stage growth model
3.3.2. Three stage growth model
4. Estimation of key inputs for dividend discount models
4.1. Estimation of earnings
4.1.1. Estimation of growth in earnings
4.2. Estimation of cost of equity
5. Free cash flow models
5.1. Reasons for using free cash flow models
5.2. Valuation of equity
6. Relative valuation models
6.1. Steps for using relative valuation model
6.1.1. Definition of the multiple
6.1.2. Other multiples
7. Summary

1. Introduction
The fundamental principle of sound investing is that an investor does not pay more for
an asset than its value. Hence, the critical element of investment management is to know
the value of an asset before buying or selling. There are many techniques to value stocks.
The following three approaches are commonly used for valuation of equity stocks:

 Balance sheet based approaches

 Discounted cash flow (DCF) models
 Dividend discount models

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 Free cash flow models

 Relative valuation models

Amongst these DCF and relative valuation models are the most widely used models. This
section is devoted for explaining balance sheet approaches and dividend discount
models.

2. BALANCE SHEET BASED APPROACHES

Every business firm maintains its books of accounts wherein all its financial transactions
are recorded. At the end of every period, normally one year, they prepare the two
statements – profit and loss account and balance sheet. While the profit and loss account
shows the incomes, expenses and finally profits made during the period, the balance
sheet shows the assets and liabilities of the business on the account closing date.
Liabilities of a firm would include owners’ funds (equity capital) and outsiders funds
(outside liabilities). Owners (shareholders in case of listed companies), are eligible for
the assets that would remain after meeting the firm’s obligations to the outsiders. Value
of equity, therefore, is the value of all the assets minus outside liabilities (it is also referred
to as net worth). In order to arrive at the value per share, one has to simply divide the net
worth by the number of shares outstanding. The value so determined is often referred to
as the book value. The approach is illustrated with an illustration below.

Illustration 2.1: The Balance Sheet of Softech Ltd for the year ended March 31,.2005 is
as follows:

Rs. Crore

Liabilities Assets
 Share capital (70 crore shares  Net fixed assets 1500
of Rs. 2 each) 140  Current assets 2500
 Reserves and surplus 2690  Deferred revenue
 Long-term borrowings --- expenses not written 30
 Current liabilities 1200 off
Total Liabilities 4030 Total Assets 4030

Book Value (BV) Per Share = Net worth / No. of shares …………………. (1)

Net worth of Softech Ltd2 = Net fixed assets + Current Assets – Current Liabilities
= 1500 + 2500 – 1200

2
Deferred revenue expenses are not assets and hence are not taken into account. Similarly, items like cumulative
losses may appear on the asset side. Therefore, one should always start from the asset side and exclude such items
for finding out the net worth/book value.

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= Rs.2800 Crore
BV per share = 2800 / 70
= Rs.40

In the investment world, the book value is rarely accepted as the intrinsic value of equity
stocks. The main reason for not accepting the book value is that the values shown in the
balance sheet are based on historical cost. Moreover, the accounting standards stipulate
that the values of different assets shall be estimated conservatively. Book value, hence,
may not reflect the true value of shares.

The following two approaches are suggested as alternatives for balance sheet based book
values:
- Liquidation value
- Replacement value

2.1 Liquidation Value

If a business is to be liquidated, what may be the value that can be realised by disposing
of all the assets of the firm? This value minus liabilities, divided by the number of shares
will give the value of a share.
Liquidation Value of All Assets  Liabilities
Liquidation Value 
Number of Shares

2.2 Replacement cost

Another way of finding out the value of shares is to consider the replacement value of all
the assets. The replacement value is the cost that may be required to build a business
firm with the same capacity and features of the existing firm. The replacement value of
assets minus liabilities, divided by number of shares, will be the value of a share.
Replacement Value of All Assets  Liabilitie s
Replacement Value 
Number of Shares
These two models too are not generally used for valuation of equity, because finding out
the market price for each and every asset of a business firm is next to impossible.

3. Dividend Discount Models

Value of any asset can be thought of as the present value of cash flows expected from the
asset. The discounted cash flow (DCF) models are available since long back and are in
vogue for valuation of most of the assets. The same are also used for valuation of equity
stocks.

The cash flows for investors in equity stocks of a company are dividends paid by the
company. In addition, they will get the terminal price when they sell the stocks. The
intrinsic value of a stock, hence, can be defined as the present value of all cash payments

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to the investor in the stock, including dividends as well as the proceeds from sale of the
stock, discounted at an appropriate risk-adjusted rate of return, k. This definition means
that the value of a share is the present value of dividend incomes and the sale price of the
stock. Mathematically,

n
Dt Pn
V0    ………………………………. (2.1)
t 1 (1  k ) t
(1  k ) n
Where,
Vo = Present value of stock
Dt = Dividend income for period t

Pn = Selling price of the stock

’k’ is the minimum rate of return expected by the investors from the stock. This
rate should include risk-free rate and the risk premium. Capital Asset Pricing
Model (CAPM) given below is the most widely used method for estimating the
discount rate.

k  R f   ( Rm  R f ) ............................. (2.2)

Where, Rf is the risk-free rate of return;  (called beta) of the stock; and
Rm is the return on a market portfolio.

Illustration 2.2: The risk free rate of return is 5% p.a, the beta of Ozone Ltd is 0.8 and
the market offers a return of 18% p.a. What is the expected rate of return for the investors
of Ozone Ltd?

k  R f   ( Rm  R f )
= 5% + 0.8 (18% - 5%)
= 15.4%

Given the expected rate of return what is the intrinsic value of the stock? Assume that
Ozone Ltd will pay a dividend of Rs.10 next year and the stock can be sold for a price of
Rs.250 at the end of the year.

D1 P1
V0  
(1  k ) (1  k )
10 250
V0  
1.154 1.154

= Rs.225.30

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One may raise the question what is Pn in equation 2.1 and how to determine that?
Assuming a holding period of one year each, the value of the stock at the beginning of the
first year is the present value of the dividend for the year and the selling price at the end
of the year. The price at the end of the year will be present value of the dividend for the
second year and the price at the end of the second year, and so on. Hence, what ultimately
matters is only dividend income. Based on this, the following four dividend discount
models have been developed:

 Zero dividend growth model

 Constant dividend growth model
 Two-stage dividend growth model, and
 Three-stage dividend growth model

3.1 Zero Dividend Growth Model

Generally, business firms retain a part of its earnings for reinvestment in the business.
However, if a company has no potential for growth, it may disburse all its earnings as
dividends. Therefore, the earnings per share and dividend per share will be equal. Since
no additional investment is being made and the business has no potential for growth the
earnings of the company too will not grow, rather it will remain constant forever. The
stream of dividends therefore will be a perpetual uniform cash flow. In this case, equation
2.1 will shrink to equation 2.3.

D1
V0  ………………………………… (2.3)
k

Where, V0 = Value of stock

D1 = Dividend for the next period.
k = Minimum required rate of return

Illustration 2.3: A stock pays a total dividend of Rs.5 in a year. The risk free rate is 6%
and the risk premium for this stock is 4%. The company is expected to maintain the
dividend at Rs.5 forever. What is the intrinsic value for the stock?

First, let us find out k.

k  R f  Risk Premium
 6  4 10%
The value of the stock is

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V0  D1 / k

 5 / .10
 Rs.50

3.2 Constant Dividend Growth Model

A firm, which does not grow, hardly exists. Supposing a firm has reached a steady state
of growth and its growth rate over time is expected to be constant. In this case, equation
2.3 shall be modified as follows:

D1
V0  ………………………………… (2.4)
kg

Where, g = the dividend growth rate. Growth rate can be calculated as follows:
g = ROE x b
Where, ROE = Return on equity, and
b = retention rate (i.e. 1 – dividend payout ratio).

Illustration 2.4: M Limited’s ROE is expected to be 25% and it follows a policy to retain
75% of its earnings. If the EPS for the forthcoming year is expected to be Rs.18, what
price will you pay for the stock? Expected return on the stock is 20%.

D1 = EPS1 x Payout Ratio

= 18 x .25
= Rs.4.5
g = ROE x b
= 25 x .75
= 18.75%
V0 = 4.5 / (0.20 - 0.1875)
= Rs.360.

Illustration 2.5: An all equity firm has Rs.100 million invested in its business. Its ROE is
15%. It follows a payout ratio of 40%. Number of shares outstanding is 3 million. Find
out the growth rate of the firm’s earnings? If the investors’ expected rate of return is
12.5% what is its intrinsic value? What is the present value of its growth opportunities?

Total earnings = Capital x ROE

= 100 mn x .15
= Rs.15 mn.
Earnings Per Share = Total earnings / No. of shares
= 15 mn /3 mn
= Rs.5

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Dividend per share = EPS x Payout Ratio

= 5 x .40
= Rs.2
Growth rate (g) = ROE x b
= 15 x .60
= 9%
V0 = 2 / (.125 - .09)
= Rs.57.14

3.2.1 Value of Growth Opportunities

Equation 5 shows that discount factor ‘k’ is adjusted for the growth rate ‘g’ and hence the
growth in the earnings of a company will contribute significantly to its stock value. One
can raise the question, how much of a stock’s value is due to the growth in its earnings?
To answer the question we should be able to decompose the value of the stock into the
value of a non-growing stock (NGV0) and the value of growth opportunities (PVGO), as
follows:

Vo  NGV o  PVGO .................................... (2.5)

Value of a non-growing stock is simply the value of the stock if the firm does not retain its
earnings. (i.e., if the firm disburses all its earnings as dividends). The value of NGVo and
PVGO of the stock in illustration 2.5 are:

E1
NGV0  ................................. (2.6)
k
5

0.125
 Rs.40

PVGO  V0  NGV0 ................................. (2.7)

 57.14  40
 Rs.17.14

If this company’s ROE in the future will be 12.5% (i.e. equal to its expected rate of return,
k), what will be its intrinsic value?

In this case, the growth rate will be 12.5 x .60 = 7.5%. Therefore, the value of the firm will
be
2
V0 
.125  .075

 Rs.40

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This is just equal to the value of a non-growing stock. The result shows that growth as
such will not increase the value of the stock. Rather, ROE being greater than the
required rate of return is a necessary condition for value creation.

3.2.3 Increasing the Value of Stocks:

The objective of the management of any business firm is to maximise the value of its
equity stocks. Given the constant dividend growth model, one can understand what
determines the value of a stock and hence what the management of a company shall do
to maximise the value of its stock. Value of stocks can be maximised by increasing the
numerator and/or by decreasing the denominator in equation 5. As such, the value of a
stock can be increased by any or a combination of the following:

 Increasing the expected dividend per share. To pay more dividends the earnings
of the firm should increase.
 Decreasing the required rate of return. The minimum required rate of return is
made up of risk-free rate, market return and beta. Risk-free rate of return and
market return are determined by the market and the management has no control
over them. The risk of the firm as measured by beta alone can be controlled by
the management. Therefore, the management shall try to minimise the beta of the
firm by taking up projects that are less risky and by making the firm’s earnings
more stable.
 Increasing the rate of growth in earnings. Growth in earnings can be increased
either by taking up projects that are more profitable than the existing businesses
and/or by maximising the profits from the existing businesses.

3.3 Variable Dividend Growth Models

The constant dividend growth model discussed above assumes that the dividends of a
company will grow at the same rate over an indefinite period. This could be true for
matured firms and firms in industries which have reached the maturity stage of its life
cycle. But in reality there are many companies whose earnings grow faster and such high
growth cannot be sustained for long. For such companies, models that would consider
multiple growth rates need to be applied. Two different models – two-stage growth model
and three-stage growth model – which are extension of the constant dividend growth
model are discussed hereunder. All the three models are widely for valuation across the
entire world.

3.3.1 Two-Stage Growth Model:

There are many companies growing at a higher rate which could be because it is a new
business or because the industry it operates in is growing at a faster rate. This high
growth rate will reach a steady state because the business firm and / or the industry will
reach a stage where the growth rate will be around the growth rate of the economy. In

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such cases, it may be expected that the extraordinary growth in earnings of a company
will continue for a certain number of years and thereafter it will reach a stable growth
rate that is sustainable for a very long period of time into the future. For such kind of
business firms, two-stage growth model can be applied for valuation of equity. The model
is

n
D0 (1  g a ) t Dn (1  g n ) 1
V0     ……………………………. (2.8)
t 1 (1  k ea ) t
(k en  g n ) (1  k ea ) n

Where, D0= Dividend for the most recent period

ga = Abnormal growth rate
gn = Normal growth rate
kea = Cost of equity during abnormal growth phase
ken = Cost of equity during normal growth phase

3.3.2 Three-Stage Growth Model:

The two-stage model assumes that after few years the growth in earnings of a company
will suddenly fall to a stable growth rate. This may be true for the companies whose
earnings are growing at a slightly higher rate than a sustainable stable growth rate.
However, if the earnings of a company are growing at a rate much higher than its stable
growth rate, the above model is not appropriate. In such cases, generally, the growth rate
will decline to the steady state over a number of years. Thus, there may be three different
stages of growth in the earnings of a company. The three stages are:

- Initial abnormal growth phase

- Transition phase
- Normal growth phase
Accordingly, the three-stage growth model is,

n1
EPS 0 (1  g a ) t pt n2
EPS n1 (1  g t ) pt EPS n 2 (1  g n ) p n 1
V0       n2
t 1 (1  k e,a ) t
t  n11 (1  k e , a ) (1  k e ,t )
n1 t
(k e,n  g n )  (1  k e,t )
t 1

……………. (2.9)

Where, Do, ga, gn, kea, ken are the same as in equation 2.8.
n1 = Number of years in the abnormal growth phase
n2 = Number of years in the abnormal growth phase plus number of years
in the transition phase.
k e,t = Cost of equity applicable to year t. It is to be noted that unlike the
abnormal growth period where a constant rate of cost of equity is used
across all the years the cost of equity for each year during the transition

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period will be different. This is because the beta will gradually change
during the transition period towards the stable period beta
p = pay out ratio

Illustration 6 explains valuation of equities applying the two-stage dividend growth model and the three-
stage dividend growth model.

Illustration 2.6: Infotech Ltd is a leading player in the I.T sector in the country. Its ROE
is expected to be 20%. Its beta is likely to be 1.35. The average return offered by the
Sensex was 14%. Risk-free rate is 6.5%. The company’s EPS for the just concluded year
was Rs.25. Its dividend pay out ratio was 0.2 and paid a dividend of Rs.5 last year.
a) Find out the value of the stock applying two-stage dividend growth model
assuming that the extraordinary growth in its earnings will continue for the next
five years and thereafter it will reach a stable growth of 10%.

b) Also find out the value of the stock applying the three-stage growth model
assuming that the extraordinary growth will continue for five years and will
decline gradually over the next five years and reach a stable growth rate of 10%.

Solution:
a) Valuation Using Two-Stage Growth Model

Cost of equity for abnormal growth period = 6.5 + 1.35 (14 – 6.5)
= 16.625%

Growth rate for the abnormal growth period = ROE x (1- Payout Ratio)
= 20 x 0.8 = 16%

Assuming that the beta of the stock during the stable growth period will be 1, cost of
equity for the stable growth period works out to 14% as shown below.

Cost of Equity for Stable Growth Period = 6.5% + 1 (14% – 6.5%)

= 14%

Retention rate during the stable growth period, assuming that the ROE will reach 15%, is
calculated as

Growth rate = ROE x Stable Period Retention Rate

So, Retention Rate = Growth Rate / ROE
= 10 / 15
= 0.67
Payout Ratio = 1- 0.67
= 0.33

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EPS for the next year is simply the EPS for the most recent year multiplied by the expected
growth rate. That is

EPS1 = EPS0 x (1+Growth Rate)

= 25 x 1.16
= 29

In the same way the EPS and DPS for the subsequent years and the present value of
dividends during the abnormal growth phase are worked out in table 2.1.
Table 2.1

Abnormal Growth Phase

Year Growth Payout EPS DPS Cost of Discount PV of
Rate Ratio Equity (kea) Factor DPS
[(1+kea)t]
1 16% 0.2 29.00 5.80 16.625% 1.16625 4.97
2 16% 0.2 33.64 6.73 16.625% 1.3601 4.95
3 16% 0.2 39.02 7.80 16.625% 1.5863 4.91
4 16% 0.2 45.27 9.05 16.625% 1.85 4.89
5 16% 0.2 52.51 10.50 16.625% 2.1575 4.87
Total 24.59

The value of the dividend cash flow during the stable growth phase may be calculated as
follows:

EPS for sixth year (EPS6 ) = EPS5 x (1+Stable Growth Rate)

= 52.51 x 1.1
= 57.76
DPS6 = EPS6 x Stable Period Payout Ratio

= 57.76 x .33
= 19.06
Value of dividends stream during stable growth phase = 19.06 / (0.14 - 0.10)

= 476.50

This value of 476.50 is at the end of abnormal growth phase (i.e. at the end of fifth year).
The present value of the amount is

= 476.50 / (1.16625)5

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= 220.86

So, Value of the Stock = 24.59 + 220.86

= Rs. 245.45

b) Valuation Using Three Stage Growth Model

The value of dividends during the abnormal growth stage is the same as in the two-stage
growth model. The present value of dividends during the transition phase is worked out
in Table 2.2.
Table 2.2

Transition Phase
Year ROE Growth Payout EPS DPS Beta Cost of (1+ k e PV of
Ratio Equity( k e )t DPS
)
6 23% 14.8% .36 60.28 21.70 1.28 16.1% 2.5049 8.66
7 21% 13.6% .35 68.48 23.97 1.21 15.575% 2.895 8.28
8 19% 12.4% .35 76.97 26.94 1.14 15.05% 3.307 8.15
9 17% 11.2% .34 85.59 29.10 1.07 14.525% 3.8145 7.63
10 15% 10% 0.33 94.15 31.07 1 14% 4.3486 7.14
39.86

Cost of equity during the transition period is declining year after year because we have
assumed that the beta of the stock will decrease gradually to 1. It may also be noted that
ROE has been assumed to decline over the transition period to reach a normal level by
the end of the abnormal period (15% in this illustration). The assumption/s is very
important because it is the basis for arriving at payout ratio and DPS. This is the only way
by which the fundamentals of the company can be taken into account in estimating the
dividends. Contrarily, if one would go strictly by equation 2.9 ROE and payout ratio will
be ignored.
The value of stable growth phase may be calculated as follows:

EPS11 = EPS10 x (1+Stable Growth Rate)

= 94.15 x 1.1
= 103.57

DPS11 = EPS10 x Stable Period Payout Ratio

= 103.57 x .33
= 34.18
34.18 1
Value of stable growth phase   5
(.14 - .10) (1.16625 x 1.161 x 1.15575 x 1.1505 x 1.14525 x 1.14)

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= 196.50

Value of the Stock = Value of Abnormal Growth Phase + Value of Transition Phase
+ Value of Stable Growth Phase

= 24.59 + 39.86 + 196.50

= Rs.260.95

Exercise: Students may find out the value of Infotech Ltd’s equity stocks by assuming
different values for beta, growth rates, ROE and payout ratios in illustration 2.6.

4. ESTIMATION OF KEY INPUTS FOR DIVIDEND DISCOUNT MODELS

The discussion in the previous section shows that the dividend discount models are of
simple equations in nature and finding the value of stocks is very easy. Contrarily, in the
investment world, valuation of equities is considered to be one of the most complex one.
What makes the valuation of equity complex? There are two main reasons. One is that the
equity shareholders are entitled to the residual earnings only. There is no upper limit
and lower limit for the residual earnings and hence the earnings available to the equity
investors need to be estimated as precisely as possible and it is very difficult. The second
reason is that the models take into account cash flows for an infinite number of periods
into the future. Predicting cash flows for infinite number of periods will be difficult.
Similarly, factors influencing the discount rate are also difficult to be identified.
Estimating the value of an equity stock, hence, does not depend much on the models but
on the reliability of assumptions and accuracy of inputs fed into the models. The critical
inputs required for applying dividend discount models for valuation of equity broadly
are: rate of growth in dividends for different time periods and cost of equity. The key
inputs necessary for using dividend discount models and how these inputs can be
estimated are discussed in this section. The section is organised into the following
sections:
 Estimation of earnings
 Estimation of cost of equity
o Risk free rate
o Market return
o Beta

4.1 Estimation of Earnings

The numerator in the dividend discount models is the dividends. Dividends are estimated
by applying the applicable growth rates over the base year dividend. If three stage growth
model is used for valuation of a stock growth rate for the abnormal growth period and
for the stable growth period are required. During the transition period the abnormal

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growth rate is normally assumed to decline linearly to reach the stable growth rate.
Growth rates for the transition years hence can be calculated if the abnormal growth rate
and stable growth rate are available. The following equation is commonly used for
estimating the growth in earnings:

Growth = Return on equity x Retention Rate

Return on equity for the future years can be estimated using the following equation:

PAT PBT PBIT Sales Avg. Total Assets

ROE      - - - - - - - - - (3.1)
PBT PBIT Sales Avg. Total Assets Equity

Where, PAT = Profit after tax

PBT = Profit before tax
PBIT = Profit before interest and tax

Thus, equation 3.1 is referred to as the DuPont Equation which takes into account the
following five factors which are the major factors influencing the ROE of any firm:
- Tax burden (the difference between PBT and PAT is income tax)
- Interest burden (the difference between PBT and PBIT is interest on
borrowings)
- Operating profit margin (PBIT/Sales)
- Total assets turnover (Sales/Avg. Total Assets)
- Financial leverage (Avg. Total Assets/Equity)

The objective of using equation 3.1 take ROE as the basis and move backward to capture
the fundamentals influencing the profitability of companies.

The ROE of the two major two wheeler manufacturing companies for the year 2015-16
has been analysed using the DuPont Equation and the results are presented in Table 3.1.

Table 3.1
DuPont Analysis of Bajaj Auto Ltd and TVS Motor Company Ltd
Bajaj Auto TVS Motor
PAT/PBT 0.61 0.74
PBT/PBIT 1.00 0.91
PBIT/Net Sales 19.7% 5.0%
Net Sales / Average Total Assets 1.45 2.35
Average Total Assets / Average Net Worth 1.36 2.67
ROE (Net of non-operating items)@ 23.7% 21.1%
Source of financial data: Ace Equity

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@: Estimated using equation 3.1. For instance, the ROE of Bajaj Auto was derived as
follows:
23.7% = 0.61 x 1.00 x 19.7% x1.45 x 1.36
Table 3.1 shows that the ROE of both the companies is more or less same. However, the
operating profit margin of TVS Motor was substantially lower at 5% compared to Bajaj
Auto’s 19.7%. Despite lower operating margin TVS motor could achieve an ROE of 21.2%
due to higher assets turnover (2.35) and higher financial leverage (2.67). Table also
shows that TVS Motor has paid tax at a lower rate 26% (1 – PAT/PBT) and has incurred
interest expense equal to 9% of its PBIT (1 – PBT/PBIT). Bajaj Auto has paid tax at 39%
and has not incurred any interest expense.

Based on realistic assumptions regarding the various factors like interest rate, leverage,
profit margin, etc, one can estimate the future maintainable ROE of any company.

4.1.1 Estimation of Growth in Earnings

Growth in earnings can then be estimated by multiplying the ROE with the retention ratio
of the company. The retention ratio can be ascertained from the dividend policy of a
company, if it is available. Or else, the average payout ratio may be worked out from its
historical earnings and dividends. Alternatively, the average for the industry may be
taken.

An alternative for estimating the growth rates is to use the historical growth in the
earnings of a company. The historical growth is generally compared with the growth in
sales to confirm the reliability of the earnings growth.

4.2 Estimation of Cost of Equity

We have already seen that the most widely used model for estimation of cost of equity is
the CAPM. The CAPM requires the following estimates:

o Risk-free rate
o Market return
o Beta

Risk-free rate: Yield from the government securities is normally taken as the proxy for
risk-free rate. There are many types of government securities with different maturity
periods. G-Sec with what maturity shall be considered for estimating the risk-free rate?
Many practitioners take the yield from 10-year G-Sec. However, all the securities
including the G-Sec are subject to inflation risk. Therefore, the right kind of G-Sec for
determining the risk-free rate is the one with the shortest term to maturity. In India, the
government security issued with the shortest term to maturity is the 91-Day Treasury
Bills and it is the most appropriate instrument for estimating the risk-free rate. There is
another issue in estimating the risk-free rate. Whether to consider the yield for the most
recent period or the yield forecasted for the future or historical average yield? It is

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suggested that the long-term average of the historical yield can be considered. The
average of the last ten years yield from 91-day T-Bills is roughly 7 percent. Whereas, the
average yield over the last 15 years ending March 2014 from the 10-Year G-Sec was
around 8.60 percent.

Market Return: Return offered by the market is inferred from a stock price index. There
are many indices in the market. Some are broader in nature comprising stocks from
various sectors and large number of stocks. Examples are Sensex, Nifty, BSE100 index
and BSE500 index. Some are sector specific like bank index, IT sector index, metal index,
etc. For the purpose of estimating the risk premium it is better to take a broader index.
Sensex and Nifty are the most commonly used indices for the purpose. The markets are
highly volatile and have offered different rates of return in the past. For instance, returns
from the Indian equity markets as measured from Nifty50 Index values have been as in
the following table:
Table 3.1
Return on Nifty 5o Index
Year Returns Year Returns
1997-98 15.35% 2007-08 23.89%
1998-99 -3.48% 2008-09 -36.19%
1999-
41.78% 2009-10 73.76%
2000
2000-01 -24.88% 2010-11 11.14%
2001-02 -1.62% 2011-12 -9.2%
2002-03 -13.40% 2012-13 7.3%
2003-04 81.14% 2013-14 18.0%
2004-05 14.89% 2014-15 26.7%
2005-06 67.15% 2015-16 -8.9%
2006-07 12.31% 2016-17 18.5%

Nifty return has been in the range of -36.19 percent (during the year 2008-09) to 81.14
percent (during the year 2003-4) during the last twenty years. It is advisable to take the
long term average return from any such broader index. The average return of the Nifty
has been 11.90 percent. This rate does not include dividend return. Assuming dividend
yield of around three percent for the Nifty50 stocks market return can be taken as 15
percent.

Beta: Capital market theorists contend that investors will be paid a premium only for
bearing the risk that cannot be eliminated through diversification. Accordingly, the CAPM
considers beta as the measure of risk. To date, beta is considered to be the only measure
available for measuring non-diversifiable risk (also referred to as systematic risk). Beta
of any stock can be measured simply by regressing the stock returns on the index returns.
This gives the historical beta. Investors, on the other hand, are concerned about

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estimating the future risk involved in their equity investment. How to forecast beta? One
way out is to calculate the historical beta and use the same as a measure of future beta.
However, it has been proved by researchers that the betas do not remain constant. It has
been found that betas have a tendency to move towards 1 (the market beta). The betas
lower than 1 increase towards 1 and higher betas decrease towards 1. Taking this into
account, Bloomberg has suggested the following approximation to arrive at the future
beta:

Future Beta = 0.67 * Historical Beta + 0.33 * 1

For example, if the historical beta of a stock has been 1.4, the estimated beta would be
1.29 (0.67 * 1.44 + 0.33).

5. FREE CASH FLOW MODELS

Sections 2 and 3 have explained the use of dividend discount models (DDMs) for valuation
of equity. The free cash flow models are extensions of DDMs. The objective of this section
is to explain the use of free cash flow models for valuation of equity.

5.1 Reasons for using Free Cash Flow Models:

The accounting earnings used in the dividend discount models are subject to
manipulation by changing the methods of accounting and by playing with some
discretionary items like depreciation. Besides, there are companies paying dividends in
excess of profits available for disbursement and there are companies paying less than
what is available. Therefore, many analysts argue that using dividends for valuation of
stocks is not appropriate. They suggest the use of free cash flows.

5.2 Valuation of equity using free cash flow models

There are two different free cash flow based methods which are:

1. Free cash flow to equity (FCFE)

2. Free cash flow to firm (FCFF)

FCFE is calculated as follows:

FCFE = Profit after tax + Depreciation – Capital Expenditures – Change in

Non-cash Working Capital + Net Debt Raised. ……………………… (4.1)

The value of a stock may be calculated by discounting the future FCFE in the same way as
discounting the dividends. The discount rate to be used is cost of equity. Add the cash
balance to the value arrived and divide it by the number of shares outstanding to arrive
the value per share. Another important thing to be noted is that the Profit After Tax (PAT)

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being taken into account for the purpose should be net of non-recurring transactions. If
strategic investments are considered for estimating the amount of capital expenses then
the income/loss from these investments should be taken into account for estimating the
value of PAT.

FCFF is the cash flow available for disbursement to all the contributors of capital
including equity shareholders and creditors. FCFF is calculated as

FCFF = EBIT (1- Tax Rate) + Depreciation – Capital Expenditures

– Change in Non-Cash Working Capital ……………………… (4.2)

FCFF model too is similar to the DDM. But the numerator is free cash flow to firm and
denominator is weighted average cost of capital (WACC).

Equity Debt
WACC  Cost of Equity   Cost of Debt (1  t ) 
( Debt  Equity ) ( Debt  Equity )
…………… (4.3)

Value of debt should be deducted from the value of firm and the cash balance and the
value of investments not considered for estimating capital expenses should be added to
arrive at the value of equity. This value should be divided by the number shares
outstanding to arrive at the value per share.

Illustration 4.1: Free Cash Flow Models for Valuation of Equity :

The following data pertains to Softech Ltd, an IT company. Find out the value of the stock
using free cash flow to equity (FCFE) and free cash flow to firm (FCFF) methods.

Table 4.1: Financials of Softech Ltd.

2011 2012 2013 2014 2015 2016
EBIT 951.86 1200.07 1510.59 2265 2801 4205
Depreciation 160.65 188.95 230.9 268 409 469
PBT 951.15 1170.02 1470.96 2231 2766 4157
Tax provision 143.19 212.09 227.49 327 345 375
PAT 807.96 957.93 1243.47 1904 2421 3782
Non-recurring income 7.76 18.84 0.53 47 48.58 29.17
Non-recurring expenses 0 25.27 9.97 1 0.45 3.05
Gross fixed assets 1111.27 1307.74 1731.57 2459 3408 4846
Investments 66.79 66.23 1027.38 1343 876 839
In group / associate cos. 7.06 15.4 95.74 159 190 839
In mutual funds 0 0 929.6 1168 684 0
Other investments 59.73 50.83 2.04 16 2 0
Inventories 0 0 0 0 0 0

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Receivables 985.87 1392.48 1325.73 2249 2715 3359

Cash & bank balance 766.95 1328.67 1638.01 1481 3334 5602
Net worth 2080.31 2860.65 3253.43 5242 6897 11162
Borrowings 0 0 0 0 0 0
Current liabilities &
provisions 481.76 736.26 1743.62 1360 2217 1824
(All figures are in Rupees crore)

Face value of a share is Rs.5 and number of shares outstanding was 571209862. The
historical beta of the company was 0.68.

WORKINGS AND SOLUTION:

FCFE Method:
The basic procedures for applying the FCFE method are the same as that for the dividend
discount models. The main difference is that the dividends in the numerator will be
replaced by FCFE. FCFE can be calculated using equation 4.1. Before applying the
equation, profit after Tax (PAT) shall be adjusted for non-recurring items. Non-recurring
expenses should be added to PAT and non-recurring incomes should be deducted. Hence,
PAT net of non-recurring transactions of the company for the year 2016 would be
Rs.3755.88 (3782+3.05-29.17). PAT (NNRT) for the different years is as follows:

Table 4.2 : PAT adjusted for non-recurring transactions

2012 2013 2014 2015 2016
PAT (NNRT) 964.36 1252.91 1858 2372.87 3755.88

Capital expenses (Capex) incurred during the year can be ascertained from finding the
increase in gross fixed assets (GFA) in a year over the previous year. Investments,
generally is the amount invested outside the business, mainly in financial assets and are
marketable. However, investment in subsidiary/group companies is of strategic in
nature and cannot be withdrawn in the normal course. Therefore, investment in
group/subsidiary companies may also be treated as capital expenses. While doing so
income from such investments should be taken into account for estimating PAT. In this
case let us assume that it has already been done so. Capex for the year 2016 thus were Rs.
2087 [(4846-3408) + (839-190)].

Non-cash working capital is inventories plus receivables minus current liabilities. For our
purpose, we have to calculate the change in the non-cash working capital over the
previous year. For the year 2016, it is Rs.1037 [(0+3359-1824) - (0+2715-2217)].

New debt raised minus debt repayments can be calculated simply by taking the debt
outstanding at the end of the year minus the debt outstanding at the end of the previous
year. This is the net debt raised by the company during the year. This company is a debt
free company and it is zero in all the years.

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Capex, change in non-cash working capital and net debt raised for the years 2012 through
2016 are as below.

Table 4.3 : Capex, change in non-cash working capital and net debt raised
2012 2013 2014 2015 2016
Capex 204.81 504.17 790.69 980 2087
-
Change in non-cash working capital 152.11 1074.11 1306.89 -391 1037
Net debt raised 0 0 0 0 0

FCFE for the years from 2012 to 2016 are as follows:

Table 4.4 : FCFE and growth in FCFE

2012 2013 2014 2015 2016
FCFE 796.39 2053.75 28.42 2192.87 1100.88
Growth (year–on- - -
year) 157.88% 98.62% 7615.94% 49.80%

For estimating the value of equity, the FCFE for the most recent year, i.e., 2016 will be the
base and applying appropriate growth rate we can estimate the cash flows expected in
the future. The compounded annual growth rate (CAGR) in FCFF of the company during
2012 – 2016 is
= (1100.88/796.39)1/4 – 1
=8.43%

The year-on-year growth of FCFE has been highly volatile and it makes it difficult to
estimate the future cash flows. Rather, the suitability of the FCFE method for valuation
of stocks based on historical values is questionable. However, for the sake of
demonstrating the model, let us use the historical growth and find out the value of the
stock. The average growth of the company’s FCFE has been 8.43 percent and which is not
abnormal. Hence, we can apply constant growth model as below.
FCFE 2008
V0 
Ke  g
We have to add outstanding cash and bank balance to the value and the resulting figure
should be divided by the number of shares to arrive at the value per share.

Bloomberg procedure is applied for estimating the beta of Softech Ltd as follows:
Beta = 0.67 x .68 + .33
= .79
Assuming a risk free rate of 7 percent and market return of 15 percent, cost of equity (Ke)
for the company is

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Ke = 7 + .79 x (15 – 7)
= 13.32%
FCFE 2008
V0   Cash Balance  Non  Strategic Investments
Ke  g
1100.88  1.0843
Value of Softech' s Equity   5602  0
.1332  .0843

= Rs.30012.72 crore
Hence, value per share = 30012,72,00,000 / 571209862
= Rs.525.42

FCFF Method
Firstly, EBIT should be adjusted for non-recurring transactions. EBIT (NNRT) for the year
2007 would be Rs.4178.88 crore (4205 - 29.17+3.05). Tax rate is simply provision for
taxes divided by profit before tax (PBT). Tax rate for the year 2016 was 9.02 percent
(375/4157). Capex and change in non-cash working capital may be taken from Table 4.3.
EBIT (NNRT), tax rate and FCFF for the years 2012 to 2016 are as follows:

Table 4.5: FCFF, EBIT adjusted for non-recurring transactions and tax rate
2012 2013 2014 2015 2016
FCFF 819.83 2085.79 64.18 2229.51 1146.91
Growth (y-on-
y) 154.42% -96.92% 3373.90% -48.56%
EBIT(NNRT) 1206.5 1520.03 2219 2752.87 4178.88
Tax Rate 18.13% 15.47% 14.66% 12.47% 9.02%
Like in FCFE method, we may use the historical growth rate for estimating the future
FCFF. The historical CAGR in FCFF is

= (1146.91/819.83)1/4 – 1
= 8.76%

As the growth rate seems to be normal, constant growth model shall be used. As the cash
flow is the cash flow available to the contributors of capital including the equity
shareholders and creditors, weighted average cost of capital (WACC) should be used as
the discounting factor. Hence,

FCFF 2008
Value of the firm   Cash
WACC  g
Softech Ltd is a debt free company and hence the weighted average cost of capital (WACC)
is equal to the cost of equity for the company.

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1146.91  1.0876
Value of Softech Ltd   5602
.1332  .0876
= Rs. 32956.72 crore

The value of debt outstanding should be deducted from the value of the firm. However,
as no debt is used by the company, the above value may be divided by the number of
shares to arrive the value per share.

Value per share = 32956,72,00,000 / 571209862

= Rs. 576.96

Important Note

Historical free cash flows (both FCFE and FCFF) will normally be highly volatile
because of non-recurring items such as capex and capital raised are being
considered for their calculation. Moreover, in case the value of cash flow in the
base year or in the latest year happens to be zero or negative the growth rate
cannot be estimated. Therefore, it is always advisable that financial statements
(profit and loss account and balance sheet) be projected and based on the
projected financial statements free cash flows may be estimated for valuation of
equity.

6. RELATIVE VALUATION MODELS

The dividend discounted models and free cash flow models discussed in the previous
sections help find out the intrinsic value of a stock. The methods give the value based on
the fundamentals of a company like earnings, growth in the earnings, dividend payout,
riskiness and the factors like leverage, interest rate and tax rate. Often the market price
of a stock diverges from its intrinsic value. This gives rise to suspecting the relevance of
the value of a stock determined based on these models. Therefore, another set of models
called relative valuation models, is widely used in the investment world. There are many
models like earnings multiples, book value multiples, revenue multiples and sector
specific multiples.

The multiples are used to determine the value of a stock in comparison to the multiple of
comparable firms. They therefore are called as relative valuation models. These models
are very popular because it is easy to compare the multiple of a firm with that of its peers
to find out whether a stock is underpriced or overpriced in the market. One can
understand the multiples easily and above all the value arrived at would reflect the
current mood of the market.

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6.1 Steps for using relative valuation models

Relative valuation models, though are easy to use, would give totally misleading results if
handled without care. The following steps may be followed diligently while applying the
models.

6.1.1 Definition of the multiple: Price-to-Earnings Ratio (PER) is the most widely used
multiple for equity valuation. Price of a stock is the numerator and earnings per share
(EPS) is the denominator in the equation. However, the price and EPS are defined
differently by different analysts. For instance, current market price may be taken as the
numerator. Alternatively, the average price of the stock over some period in the past, say,
last six months can be taken. EPS which is the denominator in the equation also defined
differently. The following three different PERs are commonly used:

 Current PE Ratio = P0 / EPS0 ……………………………. (5.1)

 Trailing PE Ratio = P0 / EPST …………………………….. (5.2)
 Forward PE Ratio = P0 / EPS1 ……………………………..(5.3)
In all the above equations, the numerator is the price of the stock which can be current
market price or average price. EPS0 is the current EPS, EPST is the trailing EPS and EPS1
is the forward EPS. EPS for the most recent accounting year is called the current EPS.
Trailing EPS is the EPS calculated from the financial statements for the most recent four
quarters or the most recent twelve months. Forward EPS is the forecasted EPS for the
current accounting year. One has to define the multiple and use it consistently across time
and stocks.
To use the multiples, one should also know the cross sectional distribution of the multiple
across the market and across the sectors. That is, knowledge of average multiple for
different industrial sectors and the multiple of different stocks within a sector is essential
to use a multiple judiciously.

It is also suggested that an analyst knows the fundamentals determining the multiple so
that he can understand the impact of the changes in the fundamentals of a company on
its multiples.

The value of a stock is determined by comparing the multiple of one company with that
of the multiple for other companies. The companies chosen for the purpose should be
comparable in terms of cash flows, growth, risk and other characteristics. An IT company
cannot be compared with a steel company. Therefore, comparable firms should be chosen
carefully. The use of PE ratio for valuation of stocks is illustrated as follows:

Illustration 9: Supposing, you are interested in finding the value of Company X’s stock
which manufactures electronics goods. There are 8 different companies in electronics
goods sector and are comparable in terms of cash flows, growth and risk. The current
market price, EPS and PE multiple for the companies are as follows:

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Current
Current Market PE
Company EPS Price Ratio
A 5 75 15
B 15 270 18
C 24 288 12
D 8 136 17
E 20 400 20
F 16 240 15
G 28 448 16
H 6 96 16
Average PE Ratio 16.125

Company X’s EPS for the last financial year was Rs.12. X’s stock value can be found by
multiplying the average PE Ratio for the industry with its EPS as follows:

Value of stock X = 16.125 x 12

= Rs. 193.50

PEG Ratio
Though there are many business firms belonging to the same industry, they differ
significantly in terms of growth. PE ratio does not consider variation in growth amongst
firms. PEG ratio given below adjusts the PE ratio for growth and is considered to be
superior to PE multiple method.

PE
PEG  ....................... (5.4)
Expected Growth Rate

PEG however, does not consider risk, the other major differentiator of stocks.

The expected growth rate and PEG ratio of the companies in illustration 5.1 were as
follows:

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Growth
Company (%) PEG
A 12 1.25
B 18 1.00
C 9 1.33
D 20 0.85
E 22 0.91
F 17 0.88
G 10 1.60
H 15 1.07
Average 1.11

Assuming that the expected growth in the earnings of company X is 14 percent, PE ratio
for the company will be found as average PEG for the industry multiplied by 14. So, the
applicable PE ratio for the company is 15.56 (1.11 x 14) and hence the value of stock X is
Rs.186.72 (15.56 x 12).

6.1.2 Other Multiples

Price-to-Book Value (P/B), Price-to-Sales(P/S), Enterprise Value-to-Earnings before

Interest, Taxes, Depreciation and Amortization (EV/EBIDTA) are some of the multiples
which are in vogue. A host of other multiples like Price to business per employee, price
to number of visitors to the website, etc which are generally sector specific are also used
by the analysts.

7. Summary
There are several methods for valuation of equity stocks. Balance sheet based models do
not provide realistic estimation of value of stocks and hence are rarely used. DDMs
consider dividends as the cash flow and value of equity stocks is estimated by discounting
forecasted dividends by cost of equity. There are four different DDMs – zero growth DDM,
constant growth DDM, two-stage growth DDM and three-stage growth DDM. Zero growth
DDM is not relevant for valuation of equity and hence is not used. The various estimates
necessary for valuation of a stock using DDMs are rate of growth in earnings, return on
equity, risk free rate, market return and beta of the stock. Valuation will be as realistic as
the estimation of these variables and hence these variables have to be estimated
considering all relevant information.

The DDMs are quite simple and easy to use. The complexity in valuation of equity lies in
estimation of the inputs needed for using the models. The key inputs/estimates needed
for using the DDMs are rate of growth in earnings, and cost of equity. Growth in earnings
of a company depends on its ROE and its dividend policy. The ROE is influenced by
multitude of factors both internal as well as external to the company. Much of the

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fundamental analysis has to do with the estimation of ROE. Dividend policy of a company
would depend mainly on its growth prospects. Greater the growth potential more capital
will be required to tap the potential and higher amount of profit will be retained and if
growth prospects are less large portion of profits will be paid as dividends.

Cost of equity is the minimum expected return by the investors and the same will be used
to discount the dividend cash flows. Cost of equity of a company can be estimated using
the CAPM. The CAPM requires risk-free rate, market return and beta of the stock. While
risk-free rate and market return are common for all stocks in a market the beta will be
different for different stocks. Beta is the only factor that will differentiate cost of equity
from stock to stock.

DDMs suffer from few deficiencies and hence free cash flow models are being used for
valuation of equity. The two most commonly used free cash flow models are FCFE and
FCFF. Under FCFE model free cash flow to equity shareholders are estimated and the
same is discounted by cost of equity. FCFF model, on the other hand, uses free cash flow
to the firm and cost of capital (WACC). Under the FCFE method the present value of cash
flows is subtracted by outstanding debt and added by cash balance on hand. The value so
derived is divided by the number of equity shares to get the value per share. Under the
FCFF method outstanding amount of debt is subtracted and the cash balance on hand is
added to the present value of free cash flows. Then the resulting value is divided by the
number of equity shares to get the value per share. Though the free cash flow models are
extensions to the DDMs the free cash flows must necessarily be estimated based on
projected financial statements.

Multiples like Price to Earnings, Price to Book Value, Price to Sales and the like are widely
used for valuation of equity stocks. Value of equity stocks is estimated by comparing a
multiple of a company with that of comparable companies. This is the reason the models
are called relative valuation models.

The first step to be followed while using relative valuation models is to define the multiple
clearly and use the definition consistently. The next step is to know the cross sectional
distribution of the multiple across sectors and across companies in various sectors. The
third step is to know the fundamental factors influencing the multiple. The fourth step is
to choose the companies that are comparable.

Among the various multiples PE multiple is the most popular one. The PE multiple
however, does not take key factors like growth in earnings and risk into account. PEG
multiple considers growth and hence is superior to PE multiple.

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Chapter 3: Portfolio Analysis, Selection and Management

Objective
The objective of this chapter is to discuss the fundamentals of portfolio analysis, portfolio
selection and portfolio management.

Structure
1. Introduction
1.1. What is a portfolio?
1.2. Traditional portfolio management
1.3. Asset allocation
2. Modern portfolio theory
2.1. The effect of diversification
2.2. Efficient frontier
3. Sharpe’s single index model
3.1. Portfolio returns and portfolio risks
4. Portfolio selection
4.1. Markowitz’s approach to portfolio optimization
4.2. Optimal portfolio
5. Summary

1. Introduction
The preceding chapters discussed how to analyse the fundamentals of a stock and how to
value the stocks based on the fundamentals. Determining the value of a stock based on
the value of comparable firms also was discussed. All these will help an investor to choose
a stock for investment and to ascertain the right price to be paid for the stock. It will also
help them identify stocks which are undervalued by the market. Hence, it will help them
make good returns. While return is one side of investment the other side is risk.
Investors wish to maximise returns but want to minimise risk. Selecting a right stock and
paying right price will not ensure minimising the risk. Spreading the investment across
various stocks and sectors will help minimise the risk. The process is called portfolio
management. The fundamentals of portfolio analysis, construction and management are
discussed in this chapter.

1.1 What is a portfolio?

Portfolio is a combination of securities and portfolio analysis considers the determination
of future risk and return in holding various blends of individual securities. Though
portfolios may consist of all sorts of assets including real and financial assets, this chapter

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will confine to portfolios of equity stocks only. However, the principles are applicable to
portfolio of any securities and any assets.

1.2 Traditional Portfolio Management

Instead of putting all eggs into one basket, it is better to spread the eggs across many
baskets so that the risk will be less. To put it in investment language, instead of parking
one’s money into a single stock, it is better to spread the investment across many stocks
belonging to different industrial sectors. Though this traditional approach emphasizes
the basic principle of managing risk through forming a portfolio, it does not say how to
measure the risk of a portfolio and what an optimal portfolio is. It, therefore, does not
help in knowing whether a particular portfolio is well diversified or not. These questions
are answered by the Modern Portfolio Theory (MPT) propounded by Harry M Markowitz
and developed further by William F Sharpe and others3.

2. Asset Allocation
To minimise the risk, investment should be diversified into many assets. It involves
selection of markets and securities and allocation of funds among the selected markets
and then into securities. Allocation can be strategic or tactical in nature. Strategic asset
allocation is allocating the funds in to different asset classes. It may be said that allocation
into different markets. For example, a fund’s investment policy is to allocate 10 percent
of funds into money market, 20 percent into dated government securities, 60 percent into
equity stocks and 10 percent cash and cash equivalents. This is a long-term strategy for
the fund and is called strategic asset allocation. There are several sectors within each
market. T-Bill market, call money market, commercial paper market and money market
mutual funds are some segments within the money market. Similarly, growth stocks,
value stocks, stocks belonging to different industrial sectors are the different types within
the equity market. Allocating the funds within these sub segments of the market and
shifting the funds from one sub segment to another or from one stock to another is
normally done more often. It is called tactical asset allocation.

Strategic asset allocation is decided largely based on the objectives of a fund. For
instance, a growth fund is supposed to park a major proportion of its funds into equities
particularly into growth sectors. Regular income funds which are expected to give
regular income to its investors have to invest more into bonds. Tactical allocation on the
other hand is done to make gains out of market fluctuations and to minimise losses when
markets behave against the expectations.
2. Modern Portfolio Theory
Managing a portfolio requires measuring its risk and return. According to Harry
Markowitz returns of a security or a portfolio can be measured by its mean and the risk

3
Markowitz and Sharpe were awarded Nobel Price in Economics for their contribution to capital
market theories.

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can be measured by standard deviation or variance. The model given by him is called the
mean-variance model.

According to him portfolio returns can be calculated as follows:

N
E ( R p )   Wi E ( Ri ) ………………………… (6.1)
i 1

Where, E(Rp) = Expected return on portfolio p.

Wi = Proportion of investment in security i.
E(Ri) = Expected return on security i.

Variance of returns is calculated as

N N
 p2   W W Cov i j i, j
i 1 j 1

This equation can be expressed as follows:

N N
 W W  i j  i j
i, j ............................................... (6.2) 4
i 1 j 1

Where,  p2 = Variance of returns of portfolio p.

Covi,j = Covariance between returns of securities i and j.
 i and  j are standard deviation of securities i and j respectively.
 i, j  Correlation coefficient between securities i and j.
The double summation sign denotes all possible covariances among the securities in the
portfolio.

Equation 6.2 can be modified for a two-security portfolio and three-security portfolio as
follows:

Variance of a portfolio of two securities A and B:

 2p  wa2 a2  wb2 b2  2wa wb  a ,b a b ………………………….. (6.3)

Variance of a portfolio of three securities A, B and C:

 2p  wa2 a2  wb2 b2  wc2 c2  2wa wb  a,b a b  2wa wc  a,c a c  2wb wc  b,c b c
………………….….(6.4)

4
Square root of variance is the standard deviation.

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The above two equations show that as the number of securities in the portfolio increases,
the calculation becomes tedious. In fact, the number of covariance terms required for
calculating the portfolio risk is n(n-1)/2. If there are ten securities in a portfolio, the
number of covariances required is 45, and if the number of securities in a portfolio is 100,
then it is 4950.

2.1 The Effect of Diversification

The MPT given by Markowitz facilitates measuring the effect of diversification and hence
one can choose the stocks that will help minimise the risk more efficiently. The theory
also helps to know the right mix of chosen securities that will have lower risk. MPT thus
helps investors to choose the right stocks to be included in a portfolio and to determine
the right proportion of funds to be invested in the chosen stocks. This is demonstrated
with an illustration below.

Illustration 6.1: Suppose there are two stocks A and B and the expected return from these stocks are as
follows:
Table 6.1
Stock A Stock B
Expected return under scenario 8% 14%
1 12% 6%
Expected return under scenario .5 .5
2
Probability of each scenario

Expected return for stock A = .5 x 8 + .5 x 12

= 10%
Expected return for stock B = .5 x 14 + .5 x 6
= 10%

Variance of returns can be calculated as

 
n
 i2   Ps Ri ,s  E ( Ri ) 2

t 1

Where, Ps = probability of scenario s

Rs = return on security i under scenario s
E(Ri,s) = expected return on security i

Variance of returns of stock A = .5(8-10)2 + .5(12-10)2

= 4%

Standard deviation of stock A = 4 = 2%

Variance of returns of stock B = .5(14 -10)2 + .5(6 -10)2

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= 16%
Standard deviation of stock B = 16
= 4%
N

 (R
i 1
i  Ri )( R j  R j )
Covariance between the two stocks = ………………. (6.5)
N
Where, Ri , R j are average returns of security i and j respectively.
N is the number of observations

(8  10)(14  10)  (12  10)(6  10)


2
= - 8.
Cov i , j
Correlation coefficient = ………………………. (6.6)
 i j
8
=
2 4
= -1

The covariance and correlation coefficient calculated above clearly indicate that the two
stocks A and B move in the opposite direction5.

Using equation (6.3), variance of a portfolio comprising 50 percent of stock A and 50

percent of stock B is calculated as below.

 2p  .5 2  4%  .5 2  16%  2  .5  .5  (1)  2%  4%
= 1%

If the proportion of investment is changed as 2/3 in stock A and 1/3 in stock B, the
variance will be
 2p  (2 / 3) 2  4%  (1 / 3) 2  16%  2  (2 / 3)  (1 / 3)  (1)  2%  4%
= 0.
The above illustration demonstrates that the effect of diversification depends on the
following three factors:

- The risk of individual securities

- The correlation between the securities
- The proportion invested in the securities

5
In the real world there may not be stocks which are negatively correlated.

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Illustration 6.2: Calculate the total risk (standard deviation) of a three security portfolio
from the following information:
Stock A Stock B Stock C
Returns 18% 12% 15%
Standard deviation of 25% 10% 18%
returns 1.0 .20 .85
Correlation with Stock A 1.0 .40
Correlation with Stock B 1.0
Correlation with Stock C .50 .30 .20
Weight in the portfolio

The values are substituted into Equation 6.4, as follows:

 .5 2  25 2  .3 2  10 2  .2 2  18 2  2  .5  .3  .2  25  10  2  .5  .2  .85  25  18
 2  .3  .2  .4  10  18
=156.25 + 9 + 12.96 + 15 + 38.25 + 4.32
= 235.78%
Standard deviation = 235.78
= 15.35%
2.2 Efficient Frontier
Modern portfolio theory assumes that the investors are rational and risk averse.
Therefore, given two assets offering the same rate of return, investors will prefer the less
risky one. An investor will take on increased risk only if he is compensated by higher
expected returns. The implication is that a rational investor will not invest in a portfolio
if for the same level of risk an alternative portfolio exists which offers higher expected
returns.

Return and risk for every possible combination of securities can be calculated and the
same can be plotted on a diagram. The return and risk of different combinations of Stock
X and Stock Y given in Table 6.2 are calculated and the results are presented in Table 6.3.
The same have been plotted in Figure 6.1. The upper part of the curve in the figure is
known as the efficient frontier (also called as "the Markowitz Frontier”). Portfolios along
this line represent portfolios offering lowest risk at a given level of return. Conversely, at
a given level of risk, the portfolios lying on the efficient frontier offer the best possible
return. The region above the upper line is not achievable because no portfolio is available
in the region. Portfolios below the upper line are suboptimal. A rational investor,
therefore, will hold a portfolio falling on the upper line only.

Table 6.2
Stock X Stock Y
Return 19 16
S.D 22 18

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Correlation 0.172

Table 6.3
Proportion Variance S.D Return Reward - to
-
Variability*
Stock X Stock Y
1 0 484.00 22.00 19.00 0.545
0.9 0.1 407.52 20.19 18.70 0.580
0.8 0.2 344.49 18.56 18.40 0.614
0.7 0.3 294.89 17.17 18.10 0.646
0.6 0.4 258.73 16.09 17.80 0.671
0.5 0.5 236.01 15.36 17.50 0.683
0.475 0.525 232.43 15.25 17.43 0.684
0.4 0.6 226.73 15.06 17.20 0.677
0.3 0.7 230.89 15.20 16.90 0.652
0.2 0.8 248.49 15.76 16.60 0.609
0.1 0.9 279.52 16.72 16.30 0.556
0 1 324.00 18.00 16.00 0.500
*Reward-to-Variability ratio = ( R p  R f ) /  p . This ratio helps in
measuring the risk adjusted performance of stocks and portfolios. In the
above example, the portfolio with a proportion of .475 invested in Stock X
and .525 in Stock Y is the best giving the highest reward-to-variability.

Figure 6.1 : Efficient Frontier

3. SHARPE’S SINGLE INDEX MODEL

Sharpe model is an extension of Markowitz’s model. According to Sharpe, instead of
finding the covariance of each security with every other security in the portfolio, it is
sufficient to find the covariance of every security with only a market portfolio. Most often
a share price index is taken as a proxy for market portfolio. The model is often referred

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to as single index model or market model. According to this model, the relationship
between the returns of a security with the index returns can be expressed as follows:

Ri   i   i Rm  ei .............................. (6.7)

Where, Ri = Return on security i.

 = The intercept coefficient.
 = The slope coefficient. It is called as beta.
Rm = Return on market portfolio.
ei = the random error term.

Beta can also be expressed as follows:

Cov i ,m
 ................................................(6.8)
2
m
 i ,m   i   m

 m2
 i ,m   i

m
Where, Covi,m = Covariance between the returns on security i and the market returns.

If returns can be measured by equation 6.7, risk (standard deviation of returns) of a

security can be measured as below.

 i     i  m   e
Where,  i and  m = Standard deviation of returns of security i and the market portfolio
respectively. Standard deviation is a measure of total risk.
  = Standard deviation of alpha. As alpha is a constant its variance is
always zero.
 i m = Systematic Risk.
 e i = Unsystematic risk which can be calculated as total risk minus
systematic risk.( i.e. unsystematic risk =  i   i m )

Illustration 6.3 : A security’s standard deviation of returns is 15 percent, and the

standard deviation of market returns is 10 percent and the beta of the security is 0.70.
Systematic risk and unsystematic risks of the security can be found as follows:

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Total risk = standard deviation

= 15%
Systematic risk = Beta x Standard deviation of market returns
= 0.70 x 10
= 7%
Unsystematic risk = Total risk – Systematic risk
= 15 – 7
= 8%

3.1 Portfolio Returns and Portfolio Risks

According to Sharpe returns of a portfolio can be calculated by equation 6.1 as given by
Markowitz. Whereas, risk of a portfolio may be measured as,

 p   Wi  i  m   Wi  e …………………………….. (6.9)

Where,  p = Standard deviation of the portfolio returns

 m = Standard deviation of market returns.
 e = Standard deviation of the error term (Unsystematic risk).

Illustration 6.4: The data pertaining to Stock X and Stock Y are given below. Assuming
50 percent investment in each of the two stocks, calculate the portfolio return and
portfolio risk.

Stock X Stock Y
Return 19% 16%
S.D 22% 18%
Beta 0.69 0.74
S.D. of Sensex 15%
Correlation between X and Y 0.172

Rp = .5 x 19 + .5 x 16
= 17.5%
Variance (Total Risk)  .5 2  22 2  .5 2  18 2  2  .5  .5  .172  22  18
= 235.93%
So, Standard Deviation = 235.93
= 15.36%

= Systematic Risk + Unsystematic Risk

Systematic Risk   Wi  i  m

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= (.5 x .69 x 15 + .5 x .74 x 15)

= 10.73%

Unsystematic Risk = Total risk – Systematic Risk

= 15.36 – 10.73
= 4.63%

4.0 PORTFOLIO SELECTION

4.1 Markowitz’s Approach to Portfolio Optimization:

Reward-to-Variability Ratio
Reward-to-variability ratio (equation 6.10) helps to identify the best portfolio based on
risk adjusted returns.
(R p  R f )
Reward-to-Variability ratio = ………………………. (6.10)
p
Where, Rp = Return on the portfolio
Rf = Risk free rate of return
 p  Risk of the portfolio
For example, there are ten different portfolios offering return and risk as in Table 6.5.

Table 6.5
Portfolio Return Risk (%)
(%) (Standard
Deviation)
A 12 4
B 14 6
C 15 8
D 16 10
E 17 8
F 20 12
G 15 14
H 18 5
I 26 20
J 10 4

Assuming a risk-free rate of 5 percent, the reward-to-variability ratio for the different
portfolios will be as follows (Table 6.5):

Table 6.5

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Portfolio Reward-to-
Variability Ratio
A 1.75
B 1.50
C 1.25
D 1.10
E 1.50
F 1.25
G 0.71
H 2.60
I 1.05
J 1.25

Amongst the ten portfolios, Portfolio H offers the highest reward-to-variability ratio and
it is the best one. Portfolio G offers the lowest reward to risk.

4.2 Optimal Portfolio

The Reward-to-Variability Ratio does not help identify the portfolios that will be most
suitable to an investor given his risk appetite. According to Markowitz, portfolio selection
may be done based on the utility of the portfolios. Utility of a portfolio depends on the
risk tolerance of an investor. Utility of a portfolio can be calculated as

Utility = Return on the portfolio – Risk Penalty ……………………. (6.11)

Risk Squared
Risk Penalty = …………………………….. (6.12)
Risk Tolerance

Where, risk squared is the variance of returns (  2p ), and

Risk tolerance is a value in the range of 0 to 100. Lower the value, less is the
investor’s tolerance towards risk, meaning that his risk appetite is less. Higher
value indicates higher risk tolerance. The value to be chosen depends on the risk
preference of an investor.

Based on the above equation, utility may be calculated for all the portfolios. Obviously,
one would select the portfolio with the highest utility.

There are two investors X and Y. X’s risk tolerance is 70 and investor Y’s tolerance is 25.
If these two investors want to choose one of the ten portfolios given in table 6.4, the utility
for them will be as given in table 6.6. Portfolio I gives the maximum utility to investor X
and hence it is his optimal portfolio. Whereas, Portfolio H is the optimal portfolio for
investor Y.

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Table 6.6 : Utility from Different Portfolios

Risk Risk Penalty Utility
Return (Standard Risk Investor Investor Investor Investor
Portfolio (%) Deviation) Squared X Y X Y
A 12 4 16 0.23 0.64 11.77 11.36
B 14 6 36 0.51 1.44 13.49 12.56
C 15 8 64 0.91 2.56 14.09 12.44
D 16 10 100 1.43 4.00 14.57 12.00
E 17 8 64 0.91 2.56 16.09 14.44
F 20 12 144 2.06 5.76 17.94 14.24
G 15 14 196 2.80 7.84 12.20 7.16
H 18 5 25 0.36 1.00 17.64 17.00
I 26 20 400 5.71 16.00 20.29 10.00
J 10 4 16 0.23 0.64 9.77 9.36

4. Summary
A portfolio is a combination of securities and portfolios help diversify risk. The factors determining the
effect of diversification are: (1) the risk of individual securities; (2) correlation among individual securities;
and (3) proportion of investment in individual securities. Portfolio analysis involves estimation of risk and
return of portfolios. The principles of portfolio analysis, portfolio selection and portfolio management are
relevant for management of all asset classes.
Traditional portfolio management does not help measure portfolio risk and does not enable
construction of optimal portfolios. Harry Markowitz, William Sharpe and others have developed the
modern portfolio theory which provides the measures for risk and return of portfolios and it also enables
construction of optimal portfolios. According to Markowitz portfolio return is the weighted average return
of all the securities in the portfolio and portfolio risk can be measured by standard deviation of the returns.
Sharpe, however, made the estimation of portfolio risk easier by introducing the market factor. According
to Sharpe, risk of individual securities as well as of portfolios can be measured by beta. His model also
enables the breaking the total risk into systematic risk (non-diversifiable risk) and unsystematic risk
(diversifiable risk).
An efficient portfolio is the one offering the highest rate of return at a given level of risk. Similarly,
a portfolio offering the lowest risk at a given level of return can also be called an efficient portfolio. Thus,
at every level of risk one efficient portfolio can be found. The curve connecting all the efficient portfolios
can be called the efficient frontier. Investors can choose an efficient portfolio from among the efficient
portfolios based on their risk appetite. One can also find out one’s optimal portfolio by finding out the utility
of portfolios. Utility of a portfolio is the difference between return of the portfolio minus risk penalty of the
portfolio. The portfolio that offers the highest utility given an investor’s risk tolerance is the optimal
portfolio for that investor.

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Chapter 4: Capital Market Theories

Objectives
The objective of the chapter is to demonstrate how the two capital market theories
– CAPM and APT – evolved and their relevance.

Structure
1. Introduction
2. Capital Asset Pricing Model (CAPM)
2.1. Capital Market Line
2.2. Security Market Line
2.3. Zero-Beta CAPM
2.4. CAPM adjusted for taxes
3. Arbitrage Pricing Theory
3.1. The arbitrage process
4. Summary

1. Introduction
The modern portfolio theory explains how the risk and return of securities and
portfolios should be measured. Capital market theories explain how the assets will
be priced in the market. Capital Asset Pricing Model (CAPM) propounded by
William Sharpe and Arbitrage Pricing Theory (APT) given by Stephen Ross are
discussed in this chapter.

2. Capital Asset Pricing Model (CAPM)

CAPM is a model that explains how the assets are priced. This model is made up
of Capital Market Line (CML) and Security Market Line (SML). Like most other
economic theories CAPM is also based on certain assumptions. They are:

1. Investors are rational and wish to maximise their expected returns. On the
other hand, they wish to minimise risk.
2. Investors choose portfolios on the basis of their expected mean and variance of
return. Mean is the measure of expected returns and variance is the measure of
risk.
3. All the investors will be holding the investments for the same length of period.

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4. There is an asset which is risk-free. Investors can do unrestricted borrowing and

lending at the risk-free rate.
5. All the information are available to investors instantaneously and at free of cost
and hence they form homogeneous expectations regarding the means, variances,
and covariances of security returns.
6. There are no taxes to be paid by investors on the income earned from the
investments.
7. There are no transaction costs to be borne by the investors.

2.1 Capital Market Line

Under the modern portfolio theory, we discussed the identification of efficient portfolios
using mean return and standard deviation of returns. Supposing there is an asset that
has no risk (having standard deviation of zero) and offers a return of 7%. An investor
wishes to allocate his funds in to this risk-free asset and a risky portfolio on the efficient
frontier. He chooses the portfolio giving a return of 17.43 percent and standard deviation
of 15.25 percent from among the various portfolios given in Table 6.3. This portfolio
offers the maximum reward to risk. Let us call this portfolio as M. The returns and risk of
different combinations of the risk-free asset and portfolio M are as follows:

Table 7.1
Proportion
Risk-
free Portfolio Portfolio Portfolio Reward-to-
Asset M Return Risk Variability Ratio
1 0 7.00% 0.00% ---
0.75 0.25 9.61% 3.81% 0.68
0.5 0.5 12.22% 7.63% 0.68
0.25 0.75 14.82% 11.44% 0.68
0 1 17.43% 15.25% 0.68

The results in the above table show that as the proportion of investment in the risky
portfolio is increased the return increases. As the return increases the risk also increases.
The last column in the table shows the reward (premium) per unit of risk as measured by
Reward-to-Variability Ratio and it is the same for all the portfolios. This relationship
establishes that the risk premium is proportional to the level of risk and hence there is
equilibrium.

CAPM assumes that unlimited borrowing and lending at the risk-free rate is possible.
Investors therefore can borrow at the risk-free rate and invest the same in risky portfolio
M. This is a leveraged portfolio and the return of the portfolio will exceed the return of
portfolio M. This relationship is shown in Table 7.2 and in Figure 7.1. The figure shows
that the portfolios falling on the straight line offer higher return at a given level of risk

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than those portfolios falling on the curved line. Thus the introduction of the risk-free asset
changes the efficient frontier from a curved line to a straight line. This line is called the
capital market line.

The return of a portfolio given in Tables 7.1 and 7.2 can be calculated applying equation
7.1.
p
R p  R f  ( Rm  R f ) ………………………………. (7.1)
m
Equation 7.1 is referred to as capital market line (CML). The equation clearly explains
the risk-return relationship and that there is a trade off between return and risk.

Table 7.2
Proportion
Risk- Reward-to-
free Portfolio Portfolio Portfolio Variability
Asset M Return Risk Ratio
1 0 7.00% 0.00% ---
0.75 0.25 9.61% 3.81% 0.68
0.5 0.5 12.22% 7.63% 0.68
0.25 0.75 14.82% 11.44% 0.68
0 1 17.43% 15.25% 0.68
-0.5 1.5 22.65% 22.88% 0.68
-1 2 27.86% 30.50% 0.68

The risk of a portfolio as per the capital market line is the weighted average of the risks
of risk-free asset and the risky portfolio M. As the risk of the risk-free asset is zero it is
simply the proportion invested in portfolio M multiplied by the risk of portfolio M.
Mathematically, risk of a portfolio as per the capital market line is

 p  Wm m ...................................................... (7.2)

As per the results given in Table 7.2, risk of portfolio M is 15.25 percent and hence if 50
percent of funds are invested in Portfolio M and the remaining 50 percent is invested in
the risk-free asset, the risk of the portfolio will be 7.63 percent (i.e., .5 x 15.25). If 100
percent of funds available is invested in portfolio M and no funds are invested in risk-free
asset, the risk of the portfolio will be equal to the risk of the portfolio M. i.e., 15.25 percent.
If the investor borrows at the risk-free rate and invests the available funds and borrowed
funds in the risky portfolio M, then risk will be more than that of portfolio M. The results
for different combinations of risk-free asset and risky portfolio M have been calculated
and shown in Table 7.2 above.

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The combination of risk-free asset and portfolio M offer the maximum return at any given
level of risk. As the investors are rational wealth maximisers they would like to invest
only in portfolio M and the risk-free asset. Therefore, the price of all other risky portfolios
are expected to adjust such that they will move towards portfolio M on the capital market
line. As a result, there will be only one risky portfolio i.e., portfolio M. Portfolio M thus
will become a portfolio of all the risky assets being traded in the market and hence it can
be called the Market Portfolio.

FIGURE 7.1: CAPITAL MARKET LINE

Capital market line
20
M
18

16
Efficient Frontier
14
Portfolio
Return

12

10

8
Rf=7%
6

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Portfolio S.D

2.2 Security Market Line / CAPM

CML explains the risk-return relationship of only efficient portfolios. It does not explain
the relationship of return and risk for inefficient portfolios and individual securities. The
risk-return relationship of portfolios falling below the efficient frontier is not explained
by the CML. Beta is a measure of systematic risk and can be used for measuring the risk
of both portfolios and individual securities. Sharpe also argues that in an efficient market
where there is equilibrium, investors will be rewarded for bearing systematic risk only6.
Systematic risk of a stock depends on its covariance with the market portfolio and hence
the risk-return relationship can be written as follows:

6
In case of a well diversified portfolio the risk that will remain is only the systematic risk which cannot be
eliminated through diversification. Accordingly, the investors holding a well diversified portfolio will expect
reward/premium for bearing the systematic risk only. Therefore, in a competitive market the prices will adjust in
such a way that the value of securities will be discounted by the market for the systematic risk only.

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Ri  R f  Rm  R f  Cov i ,m

m

Covi ,m
The expression in the above equation is nothing but beta (the slope coefficient in
m
a simple linear regression equation). Beta therefore, replaces standard deviation in
equation 7.1 as the measure of risk. The above equation hence can be replaced by
equation 7.3.

Ri  R f   i Rm  R f  ………………………………. (7.3)

Equation 7.3 is the CAPM and also called as the security market line (SML). The
relationship explained by SML is shown in figure 7.2. To draw the line in the figure, return
on the market portfolio M has been assumed to be 15 percent and risk-free rate as 7
percent. Beta of the market portfolio is always 1. SML explains the risk-return
relationship of all the portfolios (efficient as well as inefficient) and also of individual
securities. However, the measure of risk as per SML is beta which is a measure of
systematic risk.

Figure 7.2: Security Market Line

25%
20%
Returns

M
15%
10%
5%
0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta

In the real world, markets are not perfect and therefore, we cannot find the relationship
between risk and return as shown in Figure 7.2. Rather, the prices may behave within a
band and the actual relationship between the risk and return may be as shown in Figure
7.3. However, the width of the band may differ from market to market. Narrower band
implies more efficiency and wider band implies lesser efficiency. As a market becomes
more mature and efficient, the band will narrow down. This is an indication that the
degree of mispricing of securities in the market is declining.

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Figure 7.3 : SML in real world

30.00%

25.00%

20.00%
Return
15.00%

10.00%

5.00%

0.00%
0 0.5 1 1.5 2 2.5
Beta

2.3 Zero-Beta CAPM

CAPM is based on a set of assumptions listed at the beginning of this chapter. One of the assumptions is,
one can borrow and lend at the risk-free rate without any limit. In the real world, however, the borrowing
rate is normally greater than the lending rate. This assumption hence makes CAPM highly unrealistic.
Fisher Black has relaxed this assumption and has given a new model called Zero-Beta CAPM.

According to Black, a portfolio which will have no relationship with the market can be created. Since this
portfolio is not having any relationship with the market portfolio, its beta will be zero. As this portfolio
consists of risky assets one can borrow as well as invest at the rate of return offered by the portfolio. Hence,
the risk-free rate in SML can be replaced by return on the zero beta portfolio. Accordingly, the SML is
rewritten as in equation 7.4.

Ri  Rz   i Rm  Rz  ........................................... (7.4)

Where, Rz = the return on a zero beta asset.

As the return on the zero beta portfolio will be greater than the risk-free rate the slope of the SML will be
less than that of Sharpe’s SML as shown in Figure 7.4. Black’s model thus proves the relevance of CAPM.

Figure 7.4

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SML and Zero Beta SML

25.00%
SML

20.00%

M
15.00%
Return Zero Beta SML

10.00%
Rz
Rf
5.00%

0.00%
0 0.5 1 1.5 2 2.5
Beta

2.4 CAPM Adjusted for Taxes

The original CAPM also assumes that there are no taxes to be paid by the investors. Whereas, in the real
world investors have to pay taxes on their income. Nevertheless, the tax rates are different for dividend
income and for capital gains. Normally, dividends earned by investors will be taxed at normal income tax
rates and capital gains are taxed at a lower rate. Therefore, different investors falling under different tax
brackets will prefer dividend income or capital gains and accordingly they will price the securities. Michael
Brennan has considered the impact of differential taxes and has given the following tax-adjusted CAPM:

Ri  R f (1  T )   i Rm  R f  T ( Dm  R f )   TDi ……………………… (7.5)

Where,
Td  Tg
T
1  Tg
Td = Economywide average tax rate on dividend income
Tg = Economywide average tax rate on capital gains
Dm = Dividend yield on market portfolio
Di = Dividend yield on security i.

If the rates of tax on dividend income and capital gains are equal the term T in equation 7.5 will become
zero and therefore the equation will shrink to the original CAPM. Also there are arguments by academics
that evidence for the effect of taxes on the security prices is not found and hence improvement in the
original CAPM to incorporate the tax effects is of no use.

3. Arbitrage Pricing Theory (APT)

CAPM discussed above is based on the premise that there is only one factor that determines the risk of a
security or a portfolio and the returns. Contrarily, in the real world there are many factors including the
macroeconomic factors, industry factors, financial factors and the like that determine the risk and return
of securities. Stephen A Ross has developed a model which takes into account the underlying factors that
generate returns for a security. The model given by him is

E ( Ri )  R z  bi1 E ( R1 )  R z   bi 2 E ( R2 )  R z   ....
---------------- (7.6)

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Where,
E(Ri) = Expected return on security i
Rz = Return on zero-beta portfolio
[E(Ri) – Rz ] = Risk premium associated with factor i
bi = Responsiveness of the stock to the changes in factor i

The term [E(Ri) – Rz ] in equation 7.6 may be replaced by the symbol  and can be expressed in a short
form as

E ( Ri )  R z  bi  ------------------------------- (7.7)

Equation 7.7 is the arbitrage pricing model given by Ross. As can be seen, it is a multifactor model unlike
CAPM which is a single factor model. However, Ross does not say what are the factors that are priced in
the market and he also does not suggest the number of factors that should be taken into the model. Thus it
becomes a matter of empirical research to be carried out to find out the factors that need to be considered
to apply the model in practice. This is a major impediment in using the model and to date no one has come
out with the factors that can be used in the model. Because of this, the model has not become popular.

If we assume that there is only one single factor determining security returns, the APT model will become
similar to CAPM and if we assume the single factor is nothing but the market factor it will reduce to CAPM.

3.1 The arbitrage process

An arbitrage argument is used by Ross to develop APT and to prove how equilibrium in the market is
possible. Supposing market factor is the only factor that determines returns on securities and there are
four portfolios, the returns and risk of which are as in Table 7.3. The same have been shown graphically in
figure 7.5.

Table 7.3
Portfolio Returns Risk (b)
A 10.50 0.5
M 15.00 1.0
C 19.50 1.5
F 20.00 1.0

Portfolios A, M and C are falling on the straight line and hence their return is proportional to their risk.
Portfolio F is lying above the straight line and offers higher return than equilibrium return. Higher return
is available because the portfolio has been undervalued. Investors can buy this portfolio that will give them
higher return. Investors also can earn profit through riskless arbitrage. The arbitrage process is explained
as follows. Portfolios M and F have the same level of risk but F offers higher return than M. Supposing one
sells portfolio M worth Rs.10000 short and uses the proceeds to buy portfolio F. The results of this deal will
be as shown in Table 7.4. The results show that the net investment for the investor is zero and hence the
risk involved is also zero. However, he could make a gain of Rs.500. Thus the riskless arbitrage has got him
a profit of Rs 500.

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Figure 7.5
Arbitrage Process

Table 7.4
Riskless Arbitrage
Investment Returns Risk
M -10,000 -1500 -1.0
F +10000 +2000 +1.0
Net (Arbitrage Portfolio) 0 +500 0

The arbitrage process explained above involves selling portfolio M short and buying portfolio F. As more
and more investors will indulge in this arbitrage process supply of portfolio M and demand for portfolio F
will increase. Increase in supply will drive down the price of portfolio M and hence its return will increase.
Increase in demand on the other hand will lead to increase in price of portfolio F and therefore its return
will decrease. This process will continue until the return from the two portfolios will be equal. The
arbitrage process thus leads to equilibrium in the markets.

One may raise the question, portfolio M is the market portfolio and one may not be able to construct a
portfolio similar to M. In fact, portfolio similar to M can be created by combining portfolio A and C. If one
invests 50 percent of one’s funds in A and 50 percent in C the return of the new portfolio will be 15 percent
(.5 x 10.5 + .5 x 19.5). Its beta will become 1 (.5 x .5 + .5 x 1.5). Thus, one can easily create a portfolio that
will resemble portfolio M.

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4. Summary
CAPM is a model that explains how assets are priced in the market. The model is made up CML and SML.
According to the CML the measure of risk is the standard deviation and according to the SML the measure
of risk is beta. CML helps in explaining the risk-return relationship of efficient portfolios and it does not
explain the relationship of individual securities and inefficient portfolios. SML explains the risk return
relationship of all portfolios as well as individual securities. As such SML is found to be relevant and is used
in the market. For the same reason beta has been accepted as the measure of risk. Beta can be measured as
the ratio of covariance between security returns and market returns to variance of market returns. SML is
popularly known as the CAPM.

The original CAPM was developed based on many assumptions and few of them were highly restrictive in
nature and these assumptions made the model not feasible to use. However, researchers like Fisher Black
have found the model relevant even after relaxing these assumptions.

One of the major limitations of the CAPM is that it considers only one factor – the market factor. APT is a
multifactor model. However, the APT does not specify the factors to be taken into account and number of
factors. Therefore, the model is found to be practically not feasible to use. Therefore, the CAPM is being
used across all the markets in the world.

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Chapter 5: Performance Evaluation of Portfolios

Objective
This chapter discusses the measurement of portfolio returns and evaluation of their risk
adjusted performance.

Structure
1. Introduction
2. Measuring returns
3. Risk adjusted performance evaluation of portfolios
4. Breakdown of performance evaluation
5. Summary

1. Introduction
Institutional Investors like mutual funds, pension funds, employees’ provident fund,
insurance companies, banks and the like manage huge investment portfolios. These
portfolios are managed by professional fund managers. The institutional investors
actually invest other individual’s money. Individuals including high net worth individuals
hold investment portfolios. The investors employ various strategies, tools, and
techniques to earn superior returns. Nevertheless, ultimately the performance matters
and the same needs to be evaluated. Performance of investment portfolios can be
evaluated in terms of returns or in terms of risk. Higher the returns better the
performance and conversely higher the risk poorer the performance. Returns and risk
are said to be the two sides of the same coin. Evaluation of performance of portfolios
either based on return or based on risk will give one sided picture. Appropriate measure
of performance, however, is risk-adjusted returns. Various methods risk-adjusted
performance measures are explained hereunder.

2. Measuring Returns
Investment portfolios will normally offer regular income and capital gains. The regular
income would be in the form interest or dividends and will be offered to the investors
during the holding period. Capital gains is the difference between the selling price and
purchase price and will be realized at the time of selling the portfolio. Returns of a
portfolio can be measured as follows:

( NAVt  NAVt 1 )  Dt
Rp   100 ...................................................... (5.1)
NAVt 1
• Where, Rp = Return on a portfolio.

NAVt = Net asset value of the portfolio at the end of period t.

NAVt-1 = Net asset value of the portfolio at the beginning of the period t.

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Dt = Dividend income of the portfolio for the period t.

Net Asset Value (NAV) of a portfolio is the value of assets of the portfolio minus the value
of all its liabilities including fees payable to the fund managers and other administrative
expenses. Value of portfolios will be measured by considering the value of each security
in the portfolio. Value of equity funds, for instance, will be measured by multiplying the
closing prices of equity stocks by the number of shares held. To arrive at the NAV per unit
NAV of the fund should be divided by the number of units. Supposing an equity fund has
a corpus of Rs100 crore and the entire fund has been invested in equity shares. The
number of units issued is 10 crore and hence the value per unit of the fund will be Rs.10
each. If the value of the fund increases to Rs.110 crore by the end of the period and the
expenses/liabilities for the period is Rs.2 crore. The NAV of the fund therefore is Rs.108
crore (i.e., 110 – 2) and the return generated by the fund during the period is 8%. NAV
per unit will be Rs.10.8.

Illustration 5.1

Consider the data of Equity Fund and the values of share price index given in the table
below. The table provides the monthly NAV of the Equity Fund and the monthly closing
values of the Index. Given the data one can work out the month return of both the fund
and the index using equation 5.1.

For example, the returns of the Equity fund for the second month can be calculated as
follows:

Equity Fund’s return for the second month = (105 – 99) / 99 x 100
= 6.06%

Index return for the second month = (5195 – 4995) / 4995 x 100
= 4.00%
The returns for all the months are presented in Table 8.2.

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Table 5.1
NAV of
Month Equity Fund Index
1 99 4995
2 105 5195
3 98 5250
4 99 5100
5 108 5206
6 110 5300
7 112 5456
8 105 5470
9 101 5300
10 107 5425
11 115 5560
12 114 5660

Table 5.2
Monthly Returns
Month Equity Fund Index
1
2 6.06% 4.00%
3 -6.67% 1.06%
4 1.02% -2.86%
5 9.09% 2.08%
6 1.85% 1.81%
7 1.82% 2.94%
8 -6.25% 0.26%
9 -3.81% -3.11%
10 5.94% 2.36%
11 7.48% 2.49%
12 -0.87% 1.80%

Using the returns available in Table 5.2 standard deviation of returns and beta can be
calculated. Annual returns of a fund can be calculated using equation 5.1. However, for
this purpose one has to consider the value of the fund at the end of the year and the value
at the beginning of the year. The results are given in Table 5.3.

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Table 5.3
Equity Fund Index
Annual Returns 15.15% 13.31%
Std. Deviation of
Returns 5.43% 2.27%
Beta 1.26 1.00

3. Risk-Adjusted Performance Evaluation of Portfolios

Table 5.3 shows that the Equity Fund has earned higher returns than the Index. However,
the risk of the fund is higher than the Index. Therefore, there is a need for looking at the
risk-adjusted performance of the fund. The following three methods are useful to
evaluate risk-adjusted performance of portfolios.
R  Rf
Sharpe Ratio: SR  p …………………………. (5.2)
p

Rp  R f
Treynor Ratio: TR  ………………………………. (5.3)
p
Jensen’s Alpha: Rp  R f     Rm  R f  ……………………….. (5.4)
Where,
Rp = Return on the portfolio
Rm = Return on the market index
βp = Beta of the portfolio
Rf = Risk free rate of return
σp = Standard deviation of returns of the portfolio
α = Excess returns earned by the portfolio (referred to as Jensen’s alpha)
Rp – Rf = Risk premium offered by the portfolio p

Equation 8.2 is the Sharpe Ratio which gives the risk premium per unit of total risk.
Treynor Ratio (Equation 5.3) gives the risk premium per unit of systematic risk. Jensen’s
alpha (equation 5.4) gives the return offered by the portfolio in excess of the normal
return. Normal return is nothing but the return as per the CAPM. Treynor Ratio and
Jensen’s alpha consider systematic risk (beta) only. Whereas, Sharpe Ratio takes total risk
(standard deviation of returns) into account.
Performance evaluation can be done by comparing a portfolio with another or else with
a benchmark. The benchmark normally used in the investment world for performance
evaluation is a market index. Using the data available in Table 5.3 and assuming a risk-
free return of 7% performance of the Equity Fund and the Index can be measured by the
three methods as follows:

Sharpe Ratio of Equity Fund = (15.15 – 7) / 5.43

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= 1.50
Sharpe Ratio of the Index = (13.31 – 7) / 2.27
= 2.78
Treynor Ratio of Equity Fund = (15.15 – 7) /1.26
= 6.47
Treynor Ratio of the Index = (13.31 – 7) / 1.00
= 6.31
Jensen’s Alpha of Equity Fund = (15.15 – 7) = α + 1.26 x (13.31 – 7)
= 0.20
Jensen’s Alpha of the Index = (13.31 – 7) = α + 1.26 x (13.31 – 7)
=0

The above results are presented in Table 5.4. According to the Sharpe Ratio and Treynor
Ratio higher the ratio better the performance. Similarly, higher the Jensen’s Alpha better
the performance. The Equity Fund’s performance in terms of Sharpe Ratio (1.50) was
significantly poorer than the Index (2.78). Contrarily, the performance of the fund in
terms of Treynor Ratio was better than the Index. Jensen’s Alpha too shows that the
Equity Fund has performed better than the Index. Thus, the Treynor Ratio and Jensen’s
Alpha show that the Equity Fund has offered better results than the Index. Sharpe Ratio,
on the other hand, is indicating poor performance of the Equity Fund. The difference in
the results of the three methods lie in the measure of risk taken into account. The Equity
Fund’s performance was found to be good if systematic risk alone is taken into account.
If total risk is taken into account the performance of the fund is found to be not good.

Table 5.4
Equity Fund Index
Sharpe Ratio 1.50 2.78
Treynor Ratio 6.47 6.31
Jensen's Alpha 0.20% 0.00%

4. Breakdown of Performance
Eugene Fama a renowned economist has developed Equation 8.5 that helps in breaking
down the performance of portfolios.

R p  R f    Rm  R f  p
................................. (5.5)
m
Where, v = Net selectivity
Break-up of return
• Excess return earned (Selectivity)

= Rp – Normal return
= Rp – {Rf + Beta (Rm-Rf)}

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• Penalty for diversifiable risk is the premium for total risk minus premium for
systematic risk as can be measured as follows:

 p
Penalty for diversifiable risk  Rm  R f    Rm  R f 
 m 
• Net selectivity = Selectivity - Penalty for Diversifiable Risk

Table 5.5
Equity Fund Index
Return as per CML 22.13% 13.31%
Return as per SML (Normal
Return) 14.99% 13.31%
Excess Return (Rp - Rf) 8.15% 6.31%
Risk premium for total risk 15.09% 6.31%
Risk premium for systematic risk 7.95% 6.31%
Penalty for diversifiable risk 7.14% 0.00%
Selectivity 0.20% 0.00%
Net Selectivity -6.94% 0.00%

According to Fama if net selectivity is positive the performance of the portfolio is better
than the market and if it is negative the performance is poorer than the market. Fama’s
model and Sharpe Ratio give the same results regarding the performance of portfolios.
This is because both the models take total risk into account.

5. Summary
Performance of investment portfolios need to be evaluated at periodical intervals. While
return or risk can be used to evaluate performance they offer one sided picture.
Therefore, the right way to measure performance of investment portfolios is to use risk-
adjusted performance indicators. Sharpe Ratio, Treynor Ratio and Jensen’s Alpha are
widely used for evaluation of performance. Sharpe Ratio considers total risk and Treynor
Ratio and Jensen’s Alpha consider systematic risk only. Eugene Fama has developed a
model for evaluation of performance of portfolios with more details. According to Fama
the performance of a portfolio can be broken down into selectivity (return earned by a
portfolio in excess of normal return), premium for systematic risk, penalty for
diversifiable risk and net selectivity. Fama’s method thus helps understand the
performance of portfolios better.

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Equity Analysis, Valuation, and Portfolio Management

Self-Check Questions

Date: July 26, 2017 Duration: 2 hours Maximum Marks: 80

Instructions:
 Answer all the questions. Answers to all the questions may be written on the question paper itself either
by ticking the right answer or by filling up relevant boxes as may be appropriate.
 Do not write anything other than answers on this paper. Workings and rough work may be done on a
separate sheet of paper. Not abiding by this may attract negative marking.
 During the exam no clarification will be offered.

Section A (35 x 1 = 35 Marks)

1. One of the assumptions for CAPM is “the investors are risk averse wealth maximisers”. The assumption
implies which of the following?
a) Investors are greedy
b) Investors are rational
c) Investors are irrational
d) Investors would not like to take investment risk

2. CAPM after relaxing the assumption “one can borrow and lend at the risk-free rate without any limit’
was given by whom?
a) Stephen Black b) William Sharpe c) Fisher Black

3. APT is a multi-factor model. What is the number of factors to be considered in the model?
a) 10 b) 15 c) greater than 10 d) none of these

4. Mr. Hemant has Rs. 5 crore and borrows Rs. 2 crore at the risk free rate. He invests the entire amount of
Rs. 7 crore in portfolio M. Return offered by the risk-free security and the portfolio M are 6% and 14%
respectively; the standard deviation of returns of portfolio M is 10%. How much return Mr. Hemant’s
portfolio will offer?

a) 14% b) 10% c) 16.6% d) 17.2%

5. In the previous question, the standard deviation of returns of Mr. Hemant’s portfolio will be
a) 10% b) 12% c) 14% d) 15%

6. CML shows that there is trade-off between risk and return of

a) Individual securities
b) Individual securities and portfolios
c) Portfolios only
d) Efficient portfolios only

7. APT is an extension of
a) CAPM b) Zero-beta CAPM c) MPT d) None of these

8. According to the CAPM which of the following is relevant for pricing securities?

a) Systematic risk
b) Unsystematic risk
c) Both systematic risk and unsystematic risk
d) Diversifiable risk

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9. Is MRP the same for both CML and SML?

a) Yes b) No

10. According to CML the efficient frontier will be in the form of a

a) Curve b) inverted curve c) straight line

11. SML in the real world is likely to be a band rather than a line. A wider band will be considered as an
indication of

a) higher efficiency of the market

b) bigger efficiency of the market
c) lower efficiency of the market

12. The slope of Zero-Beta CAPM is likely to be

a) Steeper than the slope of CAPM

b) Less steeper than the slope of CAPM
c) The same as that of the CAPM

13. The arbitrage process explained by Ross helps the market to achieve
a) Equilibrium
b) Lower risk
c) Higher returns
d) Higher risk

14. Is it true that the STT rates are negotiable?

a) Yes b) No

15. Strategic asset allocation involves allocation of funds

a) Across various stocks
b) Across various asset classes
c) Shifting funds across various asset classes as many times as may be thought right by the fund
manager
d) Shifting funds across various securities as may be thought right by the fund manager

16. Which of the following is not a reason for the popularity of relative valuation models?
a) They capture the market mood
b) They are not influenced by the market mood
c) Simple and easy to use
d) Easy to explain to clients

17. PEG model is found to be superior to PE model because of which of the following?
a) It is easier than PE model to use
b) It considers growth in earnings into account
c) It considers growth in business into account
d) It considers historical trend into account

18. Mr. Hari has invested Rs. 10 lakh in a stock with the expectation that the price of the stock will increase
within the next one week and hence can make a quick profit. It may be called as
a) investment b) speculation c) gambling

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19. Which of the following is not needed to trade in stock exchanges?

a) trading account
b) bank account
c) demat account
d) current account

20. Which of the following risks is taken into account by Treynor Ratio?
a) Total risk b) systematic risk c) unsystematic risk d) credit risk

21. Stock A’s EPS is expected to grow at 14% and its cost of equity is 12.5%. Which of the following
models may be appropriate for valuation of the stock?
a) Gordon’s model
b) Constant dividend growth model
c) Three-stage dividend growth model

22. Stock P’s ROE is expected to be 24% and the pay-out ratio will be 40%. Hence, the EPS of the company
will grow at
a) 9.6% b) 14.4% c) 12% d) 24%

23. Selling stocks for delivery is referred to as

a) margin trade b) short selling c) intraday trade d) cash trade

24. Which of the following is needed for short selling?

a) money lending
b) lending shares
c) borrowing money
d) borrowing shares

25. Can valuation of equity stocks of banks be done using FCFF model?

a) Yes b) No

26. Equity shareholders are entitled to

a) Residual profit only

b) Dividends only
c) Assets on balance sheet only
d) Residual liabilities only

27. Margin trade enables investors to

a) lever their portfolio

b) unlever their portfolio
c) Neither ‘a’ nor ‘b’

28. Basic principles to be followed for using relative valuation models include

a) Multiples must be defined clearly

b) The definition should be used consistently
c) The multiple should be compared with that of comparable firms

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d) All the above

e) Both ‘a’ and ‘b’

29. Intraday trade allows

a) Trading for delivery only
b) Margin trade only
c) Short selling only
d) Both ‘b’ and ‘c’
e) All the above

30. ROE of Ostrich Ltd is expected to be 20% and its earnings are expected to grow at 8%. Hence, its payout
ratio is supposed to be
a) 40% b) 60% c) 2.5 d) cannot be estimated

31. In India, tax on dividend income is paid

a) By investors at 20%
b) By investors at the normal income tax rate
c) At the source
d) None of the above

32. PE Ratio calculated with the EPS for the year 2017-18 may be called as

a) Current PE Ratio b) Trailing PE Ratio c) Forward PE Ratio

33. The discount rate to be used in the FCFF model is

a) Ke b) WACC c) Rm d) Rf

34. Is capex in the FCF models estimated the same way as in cash flow statement?
a) Yes b) No

35. Historical beta of Amla Ltd was 0.7. If the beta is adjusted using the method suggested by Bloomberg it
will
a) Increase b) decrease c) remain the same

Section B (45 marks)

Data for Questions 36 and 37: Foody Ltd.’s DPS for the last year was Rs. 10; its ROE is expected to be 15% in
the future and its dividend policy is to payout 60% of its earnings as dividends. The beta of the company is 0.6,
market return 14% and risk-free rate 6%.

Question No. Answer Marks

36. Value of the Stock 5

37. Value of the stock if beta is 3

assumed to be 0.9

38. The present value of FCFFs of Sonic Ltd is Rs. 1400 crore. Cash balance, investments and borrowings
of the company outstanding at the end of last year were Rs. 10 crore, Rs.80 crore and Rs.200 crore
respectively. The number of shares of the company issued and paid up were 8 crore.

The value of the stock is Rs. _______________ (3 marks)

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39. Stock X is currently trading at Rs.140. EPS of the company for the last financial year was Rs.9 and it is
expected to grow at 6%.

Answer Marks
Forward PE Ratio of Stock X 2

PEG Ratio of Stock X 2

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Table 1: Data for answering questions 40 - 42

Portfolio Return (%) S.D of Returns (%) Beta
X 18 16 1
Y 22 25 1.1
Z 15 13 0.8
Market 14 12 1
Risk-free Asset 8 0 0
Risk Tolerance
of Anil 20
Risk Tolerance
of Manish 60

40. Using the data given in Table 1 fill-in the blank cells in the table below.

Utility for
Portfolio Anil Manish
X
Y
Z
Marks 6 6

41. The optimal portfolio for Anil is (1 mark)

a) Portfolio X b) Portfolio Y c) Portfolio Z

42. The optimal portfolio for Manish is (1 mark)

b) Portfolio X b) Portfolio Y c) Portfolio Z

For Questions 43 – 45: Mr. Mukund has learned from various reports and the media that the economy will start
slowing down shortly. His present portfolio of equity stocks is risky with a beta of 1.5 and it will be hit very badly
if the economy slows down. Though he has consciously constructed a high risk portfolio to earn high returns he
wants to minimise the risk of his portfolio, as a tactical move, by investing 40% of his fund in either of the two
alternatives - Stock P or Stock Q. Assume a risk-free rate of 8%. Some statistics about the two stocks and
Mukund’s existing portfolio are as follows:

Return (%) Standard Deviation of Returns Beta Correlation with

(%) Existing Portfolio
Existing Portfolio 20 32 1.5 1
Stock P 14 21 0.5 0.3
Stock Q 23 26 1.2 0.6

43. Fill up the following table.

Existing Portfolio and Existing Portfolio and Marks

Stock P Stock Q
Portfolio returns 2

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Portfolio standard 6
deviation

Reward to risk ratio 2

44. Also estimate portfolio beta for both the alternatives.

Existing Portfolio and Existing Portfolio and Marks
Stock P Stock Q
Portfolio Beta 4

45. Explain whether Mukund’s tactical move to invest in a low beta stock is a step in the right direction.
(2 marks)

--- The End ---

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